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BASEL II: CAPITAL CHANGES IN

THE U.S. BANKING SYSTEM AND

THE RESULTS OF THE IMPACT STUDY

JOINT HEARING

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

AND THE

SUBCOMMITTEE ON 

DOMESTIC AND INTERNATIONAL 

MONETARY POLICY, TRADE AND TECHNOLOGY

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

MAY 11, 2005

Printed for the use of the Committee on Financial Services

Serial No. 109–27

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

RICHARD H. BAKER, Louisiana 

DEBORAH PRYCE, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

JUDY BIGGERT, Illinois 

CHRISTOPHER SHAYS, Connecticut 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

JIM GERLACH, Pennsylvania 

STEVAN PEARCE, New Mexico 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

MICHAEL G. FITZPATRICK, Pennsylvania 

GEOFF DAVIS, Kentucky 

PATRICK T. MCHENRY, North Carolina 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

GWEN MOORE, Wisconsin, 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND CONSUMER CREDIT

SPENCER BACHUS, Alabama, Chairman

WALTER B. JONES, JR., North Carolina, 

Vice Chairman 

RICHARD H. BAKER, Louisiana 

MICHAEL N. CASTLE, Delaware 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

SUE W. KELLY, New York 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

JUDY BIGGERT, Illinois 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

PATRICK J. TIBERI, Ohio 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

RICK RENZI, Arizona 

STEVAN PEARCE, New Mexico 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

PATRICK T. MCHENRY, North Carolina 

MICHAEL G. OXLEY, Ohio 

BERNARD SANDERS, Vermont 

CAROLYN B. MALONEY, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

LUIS V. GUTIERREZ, Illinois 

DENNIS MOORE, Kansas 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

AL GREEN, Texas 

GWEN MOORE, Wisconsin 

WM. LACY CLAY, Missouri 

JIM MATHESON, Utah 

BARNEY FRANK, Massachusetts 

(IV)

SUBCOMMITTEE ON DOMESTIC AND INTERNATIONAL MONETARY POLICY, TRADE AND

TECHNOLOGY

DEBORAH PRYCE, Ohio, Chair

JUDY BIGGERT, Illinois, Vice Chair 

JAMES A. LEACH, Iowa 

MICHAEL N. CASTLE, Delaware 

FRANK D. LUCAS, Oklahoma 

RON PAUL, Texas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

MARK R. KENNEDY, Minnesota 

KATHERINE HARRIS, Florida 

JIM GERLACH, Pennsylvania 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

PATRICK T. MCHENRY, North Carolina 

MICHAEL G. OXLEY, Ohio 

CAROLYN B. MALONEY, New York 

BERNARD SANDERS, Vermont 

MELVIN L. WATT, North Carolina 

MAXINE WATERS, California 

BARBARA LEE, California 

PAUL E. KANJORSKI, Pennsylvania 

BRAD SHERMAN, California 

LUIS V. GUTIERREZ, Illinois 

MELISSA L. BEAN, Illinois 

DEBBIE WASSERMAN SCHULTZ, Florida 

GWEN MOORE, Wisconsin 

JOSEPH CROWLEY, New York 

BARNEY FRANK, Massachusetts 

(V)

C O N T E N T S 

Page 

Hearing held on: 

May 11, 2005 ..................................................................................................... 1

Appendix: 

May 11, 2005 ..................................................................................................... 45

WITNESSES 

WEDNESDAY, MAY 11, 2005

Bies, Hon. Susan Schmidt, Governor, U.S. Federal Reserve Board of Governors .................................................................................................................... 9

Curry, Hon. Thomas J., Director, Federal Deposit Insurance Corporation ........ 15

Follain, James R., Senior Vice President of Mortgage Valuation, Fidelity 

Hansen Quality .................................................................................................... 34

Riccobono, Richard M., Acting Director, Office of Thrift Supervision ................. 11

Small, William J., Chairman and CEO, First Federal Bank, Representing 

America’s Community Bankers ........................................................................... 33

Williams, Julie, Acting Director, Office of the Comptroller of the Currency ...... 13

APPENDIX 

Prepared statements: 

Oxley, Hon. Michael G. .................................................................................... 46

Bachus, Hon. Spencer ...................................................................................... 48

Bies, Hon. Susan Schmidt ............................................................................... 52

Calem, Paul S. and Follain, James R. ............................................................ 63

Curry, Hon. Thomas J. ..................................................................................... 103

Petrou, Karen Shaw ......................................................................................... 130

Riccobono, Richard M. ...................................................................................... 147

Small, William J. .............................................................................................. 166

Williams, Julie .................................................................................................. 173

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Bachus, Hon. Spencer: 

Additional questions for the record for Karen Shaw Petrou ......................... 193

Conference of State Bank Supervisors, prepared statement ........................ 194

‘‘In Focus: Stress Shows At Fed with Basel II Drive Sputtering’’ article 

from American Banker, August 29, 2005 .................................................... 198

Barnett Sivon & Natter, prepared statement ....................................................... 202

Independent Community Bankers of America, prepared statement ................... 212

National Association of Realtors, prepared statement ......................................... 223

The Real Estate Roundtable, prepared statement ................................................ 220

Petrou, Karen Shaw: 

Response to questions from Hon. Spencer Bachus ........................................ 228

(1)

BASEL II: CAPITAL CHANGES IN 

THE U.S. BANKING SYSTEM AND 

THE RESULTS OF THE IMPACT STUDY 

Wednesday, May 11, 2005

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

AND CONSUMER CREDIT, 

JOINT WITH THE

SUBCOMMITTEE ON DOMESTIC AND INTERNATIONAL

MONETARY POLICY, TRADE, AND TECHNOLOGY

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 10:04 a.m., in Room 

2120, Rayburn House Office Building, Hon. Spencer Bachus [chairman of the subcommittee] presiding. 

Present: Bachus, Oxley, Leach, Pryce, Gillmor, Biggert, Kennedy, 

Feeney, Hensarling, Pearce, Neugebauer, Price, McHenry, Frank, 

Maloney, Lee, Moore of Kansas, Ford, Baca, Matheson, Green, and 

Wasserman Schultz. 

Mr. BACHUS. [Presiding.] Today, the Subcommittees on Financial 

Institutions and Consumer Credit and Domestic and International 

Monetary Policy are meeting to examine the proposed Basel II capital accord and its potential effects on the domestic and international banking systems, as well as on the recently completed 

fourth Qualitative Impact Study, QIS-4. 

I expect that Chairman Pryce will be here in about 20 minutes. 

She will submit a statement for the record. I appreciate her participation in this hearing. 

Today’s hearing is the fourth one that the Financial Services 

Committee has held on Basel II proposals since the 106th Congress. Prior hearings have highlighted disagreements among the 

Federal financial regulators, as well as substantive problems. 

During the last Congress in response to concerns about the Basel 

process, I, along with Congresswoman Maloney, Chairman Oxley, 

and Ranking Member Frank, introduced H.R. 2043, the United 

States Financial Policy Committee for Fair Capital Standards Act. 

The legislation, which passed out of the committee I serve as chairman by unanimous vote, mandated that the Federal banking regulators develop a unified U.S. position among the agencies prior to 

entering into negotiations in the Basel committee. 

In March, Congressman Maloney and I introduced the same legislation, H.R. 1226, with 36 cosponsors. Let me start by applauding 

the bank regulators for delaying the notice for proposed rulemaking 

2

to implement Basel II in response to the results of QIS-4. I have 

been concerned that the regulators have been overly committed to 

an arbitrary timeline and have been making decisions that fit into 

their schedule without fully understanding the consequences. 

Many banks that may choose to adopt voluntarily Basel II have 

expressed concerns about being forced to make significant investments without having the full knowledge of the impact Basel II 

may have on their operations. As I said before, I am encouraged 

that the regulators have recognized some of these problems with 

Basel II and hope that common sense will continue to prevail, even 

if it means delaying the implementation of Basel II beyond the 

January 1, 2008 deadline. 

The goal of Basel II is to develop a more flexible and forwardlooking capital adequacy framework that better reflects the risk 

facing banks and encourages them to make ongoing improvements 

to their risk assessment capabilities. Over the past 6 years, the 

United States Federal banking regulators have engaged in negotiations with their foreign counterparts on possible improvements to 

the standards that govern the capital that depository institutions 

must hold against their assets. 

The Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Office of 

Thrift Supervision participated in those negotiations on behalf of 

the U.S. Their representatives will be testifying on our first panel. 

It is expected that when ultimately implemented, Basel II will 

apply mainly to the largest, most internationally active banks and 

others that voluntarily adopt it. The remaining institutions in the 

United States will continue to operate under the original Basel accord, or Basel I. 

A growing international consensus has developed that Basel I is 

outdated and represents a one-size-fits-all approach to regulation, 

causing some banks to hold too much capital and thus diverting 

capital from productive lending activities. Additionally, the Basel 

accord has been criticized for worsening credit crunches, creating 

incentives for banks to undertake destabilizing short-term lending 

in emerging markets, for not taking into consideration risk mitigation, creating incentives for banks to securitize expensive assets, 

and for not addressing credit risk transfers through derivatives. 

I applaud the intent and objectives of the Basel II agreement to 

ensure solvency of our banking institutions and protect against 

substantial losses by creating a more risk-sensitive regulatory capital framework and to create international standards to manage 

risk better by aligning regulatory capital to economic risk. 

Nonetheless, I and other committee members have concerns regarding Basel II for several grounds. 

First, we believe it is unnecessarily complex and costly, with inflexible formulas replacing current rules and supervisory examinations. You can see from the formula that we have displayed that 

it highlights some of that complexity. 

Neither the U.S. regulators nor the Basel II committee members 

nor the banks can estimate the cost of implementing the Basel II 

due to costs associated with scaling for different size banks and difficulties in assessing which costs would already have been undertaken by the banks in the ordinary course of business. 

3

No U.S. banking regulator nor any member of the Basel committee has indicated whether sufficient resources exist to implement Basel II. The documents and charts in front of you, as I say, 

illustrate this point. There are 187 publicly available documents related to Basel II weighing 127 pounds. While some ideas included 

in these documents have evolved, the amount of paper demonstrates the complexity and micromanagement that Basel II represents. 

In addition, the chart with all the letters and numbers is the 

Basel II formula itself. I have no doubt that there are very few people who understand this formula or its implications. It looks like 

a formula for micromanaging the banking business, rather than 

one designed to align regulatory and economic capital assessments. 

In addition, I believe that the current draft would create an uneven 

playing field, one that unfairly penalizes many banks in the country, particularly our regional banks. 

Many believe that Basel II banks will have a significant competitive advantage because they will need to hold less regulatory capital for certain asset classes, for example credit cards, corporate 

lending, and mortgages, and because mortgage participants will 

perceive Basel II banks to be better managed than Basel I banks. 

I am also concerned that bank consolidation could be accelerated 

solely because of the regulatory capital benefits associated with 

Basel II implementation. 

The uneven playing field would carry over across borders, since 

the proposal expressly contemplates over 50 opportunities for local 

regulators to tinker with this formula. What is more, the Basel 

committee itself has not yet figured out how regulators will communicate and work together with each other to set meaningful regulatory capital requirements for globally active banks that have operations in multiple countries. How one could end up with an international common standard in this situation is difficult to perceive. 

Another concern that we have with the proposal is the treatment 

of operational risk. It is my belief that a supervisory assessment 

by the regulator, as opposed to a regulatory capital cover, is the 

better approach to limiting a bank’s operational risk. 

It is my understanding that the databases are insufficiently robust for banks to provide meaningful input into the QIS process. 

If so, how can we implement these requirements without knowing 

how they will impact real banks and real portfolios? How can the 

regulators have confidence that the systems will be in place by the 

supposed implementation date? What if the data at that stage generates unexpected answers as they do now, as the credit risk numbers have done for QIS-4? What do we do then? 

At today’s hearings we will hear from a distinguished panel of 

regulators, including Federal Reserve Governor Susan Bies, Acting 

Comptroller of the Currency Julie Williams, FDIC Director Tom J. 

Curry, and Acting Office of Thrift Supervision Director Richard 

Riccobono, as well as a panel of private sector witnesses. I look forward to hearing from today’s witnesses, and thank them for taking 

time from their busy schedules to join us. 

I am now pleased to recognize the Ranking Member. Actually, in 

his absence, I am going to recognize the gentlelady from New York, 

Ms. Maloney. 

4

[The prepared statement of Hon. Spencer Bachus can be found 

on page 48 in the appendix.] 

Mrs. MALONEY. Thank you, Mr. Chairman. 

I thank all our witnesses and everyone who is here that is concerned about this issue. This is the fourth hearing that we have 

called. This is very much of a bipartisan concern. We have had several that have focused on it. 

The first Basel Capital Accord established minimum standards 

for banks that operate internationally. Basel II is an attempt to update this accord by allowing financial institutions to hold capital in 

a balance more reflective of risk and changing market conditions. 

From the beginning of the negotiations, I have been concerned, as 

many of my colleagues have been, that the U.S. regulators need to 

address these negotiations from a consistent and coordinated viewpoint and to start from the premise that the new standards do not 

put American financial institutions or any segment of them at a 

competitive disadvantage. 

In the last Congress, we legislated. We held hearings that really 

called upon U.S. regulators to develop a uniform position before negotiating in the Basel committee. Once implemented, the final capital accord will have profound consequences for the banking industry, our constituents, and the economy of our country. We must 

take the time and the focus to get this right. 

The results of the QIS-4 study I find very disturbing. It shows 

that some banks adopting the proposed Basel II standards will be 

able to reduce their regulatory capital considerably and, thus, gain 

a competitive advantage with other domestic banks that may not 

be in Basel. More disturbingly, the amount by which a bank might 

be able to reduce its regulatory capital varied widely among banks 

that appeared to be very similar, to have similar portfolios, and 

should, in theory, be treated equally under the new standards. 

These results do not support, and indeed actually cut against, 

the reassurances we have consistently received from the regulators 

that the new standards have been designed to treat like-risk alike 

and establish an international level playing field. I am concerned 

that they also suggest that the complexity of the new standards 

makes them more prone to widely differing interpretation and results. 

The stacks of paper that have been put there by the majority 

staff, that is the proposal for Basel II. It is very long, and over here 

is the formula. If you look at the number of variables in this formula on this chart, each of them represents an opportunity for a 

regulator to tweak the definition of that variable so to put a home 

bank at an advantage. This, at least, is a formula for confusion. 

I am very concerned. I know that our regulators are going to be 

very tough on American institutions. I am not so convinced that 

foreign regulators are, in very small countries and in other countries. I am afraid that that might put us at a disadvantage. If the 

regulators themselves do not understand the reason for the differences that came out in the QIS-4 study, then how can they hope 

to effectively monitor and supervise compliance? I have not seen 

any explanation that explains why so many like banks with like 

portfolios came up with different conclusions. 

5

Former Comptroller Jerry Hawke was highly critical of what he 

termed ‘‘the monumental prescriptiveness’’ of the Basel II standard. Unfortunately, these widely disparate results demonstrate 

that his concerns, which I share, appear to have a basis in fact. I 

hope that we will have this clarified by the witnesses. 

I would like to say that why don’t we just have a simpler rule, 

just Basel I plus something that applies uniformly, that would 

move more banks, and the United States would be able to comply 

with it? I am very concerned about this highly confusing formula 

that has many opportunities to be tweaked and interpreted in various ways by various regulators in other countries. 

So I thank you for all of your hard work, and I look forward to 

your testimony. 

I yield back. 

Mr. BACHUS. Thank you. 

At this time, I would recognize the ranking member of the full 

committee, Mr. Frank. 

Mr. FRANK. Thank you, Mr. Chairman. I appreciate the diligence 

with which you have been pursuing this. 

I have some questions about the technical aspects of the formula, 

but I will defer those and submit them in writing in deference to 

the recorder. 

The concern I do have, though, is touched on by the comptroller’s 

testimony and the FDIC’s testimony. I have not had a chance to 

read the OTS testimony yet. But in particular in the testimony in 

the FDIC, it is especially the concern for the competitive effects. I 

appreciate Mr. Curry’s very straightforward statements that if you 

go ahead with Basel II and do nothing else, you put smaller banks 

at a disadvantage. 

Now we already have a problem. We are in a controversy now 

over deposit insurance. This House passed a bill that would increase deposit insurance not by a huge amount, $30,000. The likelihood is that that will not survive in the Senate. I supported it, but 

it may not survive. That, smaller banks argue, is something of a 

disadvantage for them. It is a perceptual disadvantage from people 

who have large deposits to make and think the bigger the bank, 

the less likely it is to fail, or be allowed to fail; therefore they go 

toward the bigger banks. 

We are, I think, this is not an abstract consideration. Big banks 

are fine, but big banks to the exclusion of little banks are not so 

fine. I want to give a little bit of experience here. A few years ago, 

Mr. Curry would remember, he was there at the time, Fleet and 

Bank Boston merged. There were at the time a number of overlapping branches. The question was, what do you do with the overlapping branches? 

There was a proposal from the antitrust regulators, both State 

and Federal, that they be packaged together and sold to one large 

outside bank because that would be more competition for Fleet and 

Bank Boston. It seems somewhat nostalgic to talk about a large 

New England bank, doesn’t it? But that is where we then were, but 

that is relevant to the pace at which consolidation is moving and 

underlies these concerns. 

Overwhelmingly, my colleagues in Congress and I heard not from 

banks, but from borrowers, small borrowers, local Chambers of 

6

Commerce, retailers, homebuilders, people who were in the local 

markets: Please do not do that; we do not want to have to deal 

with the very large banks; we want to deal with local banks. 

We argued for a divestiture of at least some of those overlapping 

branches to community banks. We were successful in getting I 

think about 12 or 15 percent, but not enough. I remember, frankly, 

the Boston Globe was critical. They said we were shilling for Fleet 

by preventing a big competitor. A year later, they had an article 

saying, well, it turns out that there is greater consumer satisfaction with the smaller banks. Big banks have their role and so do 

smaller banks. 

Public policy and the economy and the economies of scale and all 

these other factors are tending to drive us toward consolidation. In 

Massachusetts, as former Commissioner Curry knows, the relevant 

analogous committee to us is called the Committee on Banks and 

Banking. Someone said, are you ever going to change the name 

back here to the Committee on Banks? I said no. By that time, we 

will call it the Committee on the Bank because there will be one 

in the whole country at the way we are going. 

It is not in our interest to accelerate that trend. We have very 

strong, very explicit testimony from the regulators, particularly 

those of the smaller banks. The Federal Reserve deals with the 

bank holding companies, but the FDIC, particularly the smaller 

banks, and the Comptroller, both of them argue that there is a negative competitive effect. I must tell you, I cannot see any argument 

for going ahead with adopting a policy that will increase the pressure on smaller banks and increase the competitive advantage that 

goes to larger banks, with no comparable consumer advantage in 

this case, by itself. 

I know people have said, well, after we do this, then we can do 

that. Well, that could come before this as well. So I think a heavy 

burden of proof goes on those who tell us that. 

The final thing I would say is this, Mr. Chairman. I note, and 

Governor Bies, who has been very cooperative and has met with us, 

and I appreciate the Federal Reserve’s willingness to talk with us 

about this, but maybe it was one of the others; maybe it was Ms. 

Williams who said: Remember, once we go through with Basel II, 

we still have to adopt it, the bank regulators. 

But I will ask, I may not be able to stick around, but I would 

hope you would answer, ′′Yes, but with what freedom?′′ If we are 

a signatory to Basel II, are we free to disregard it? I mean, it is 

true that it does not automatically go into effect, you tell me, but 

it does seem to me that we would be under serious constraints. The 

likelihood that we could as we adopted it ignore some of the major 

factors is a problem. 

So this conceded competitive disadvantage for smaller banks is 

a greater obstacle, it seems to me, than any of the advantages. At 

the very least, it rates a very strong argument that the timing is 

out of whack and that there is no reason why we should not be able 

to at least proceed simultaneously. That is, I will take a lot of convincing that we should decrease capital requirements for the larger 

banks before we do the other. 

One last point, if I could, Mr. Chairman. I would just note that 

there has been some concern expressed in other quarters on a matVerDate 0ct 09 2002 14:39 Jan 11, 2006 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 G:\DOCS\109.27 RODNEY
7

ter we are going to be dealing with, the Fannie Mae and Freddie 

Mac, on the danger of them holding mortgages in their own portfolio, rather than securitizing it, on the grounds that this will add 

to credit risk. I was very pleased when we wrote Governor Bies on 

this subject because it has something to do with Basel and other 

things. Here is what she said: ‘‘Adopting institutions are likely to 

hold more mortgages on their balance sheets after Basel II.’’

This is about Basel II, but it seems to me it has some relevance 

here. ‘‘Since most of the likely increased holdings would come from 

those that are now being securitized, these additional mortgages 

would generally be of high quality, as are most residential mortgages that are currently securitized. That is while mortgage portfolios of adopting institutions may be larger and we would not expect a significant increase in the credit risk of bank mortgage portfolios.’’

In other words, when you are talking about mortgages which are 

already of sufficient quality to be securitized, whether they are 

held on the balance sheet of the institution or securitized does not 

affect credit risk. I guess I will need to be persuaded by the Federal 

Reserve why what is sauce for the Basel goose is not sauce for the 

GSE gander. 

Thank you, Mr. Chairman. 

Mr. BACHUS. Thank you. 

I now recognize the chairman of the full committee, Chairman 

Oxley. 

Mr. OXLEY. Thank you, Mr. Chairman. 

I first want to associate myself with the excellent remarks of the 

ranking member from Massachusetts. I want to thank you and 

Chairwoman Pryce for calling today’s hearing on the proposed 

changes to the Basel accord. You have been a real leader on the 

issue of Basel II reform, and it is most appreciated. 

Significant changes to the proposal have been made in response 

to your concerns additionally by bringing attention to this process. 

The committee has seen increased cooperation among U.S. regulators who are developing Basel II. Basel II is critically important 

to every bank in the United States and the rest of the world, and 

it will determine how much regulatory capital must be held to 

cover risk in bank portfolios, domestically and globally. 

Capital standards also influence market perceptions of a bank’s 

strength, which directly impacts ratings decisions. I do not think 

you will find much argument that the Basel accord is outdated and 

needs revision. This developed in the late 1980s before liquid markets for credit had been developed and before the derivatives and 

securitization markets had taken off. These developments have 

made the Basel accord obsolete and prone to abuse. 

The most recent impact study conducted by the U.S. regulators, 

QIS-4, shows major swings in how much regulatory capital banks 

using this new framework might need to hold. Participants estimated decreases of as much as 40 percent. Others estimated increases of as much as 60 percent from the current standard. Even 

though no bank came close to breaching the leverage ratio, these 

kinds of results are unacceptable. No one knows why these results 

came out the way they did. In other words, no one in the regulatory 

community seems to know how the new framework will affect retail 

8

credit markets in the United States, particularly credit cards and 

mortgages. 

These market sectors are the backbone of our economy and permit the United States to serve as the sole engine of economic 

growth among developed economies in the world. I believe it would 

be irresponsible to proceed quickly under these circumstances, and 

the regulators were wise to pause before finalizing Basel II. It 

would be helpful to know how the regulators are progressing with 

all the various data problems and when we will have a greater understanding of the QIS data. 

I would encourage the U.S. regulators to allow time for all the 

data to be understood before making any international commitments regarding final text and implementation. Regulators also 

should be discussing how they will cooperate in order to implement 

the new framework. 

Significant changes in Basel II may be needed here and abroad 

before a final proposal is ready. In the meantime, I believe that 

U.S. regulators should continue working on updating the Basel accord so that banks in the United States can benefit from the 

changes in the obsolete framework while regulators try to put together a functional Basel II proposal. It seems that this would be 

the most equitable way to make improvements to the capital standards. 

I am interested in hearing what the witnesses think about this. 

We welcome the distinguished panel of experts and regulators who 

have worked tirelessly to implement and to in some cases correct 

some of the problems that were heretofore mentioned. 

I thank the Chair, and I yield back. 

[The prepared statement of Hon. Michael G. Oxley can be found 

on page 46 in the appendix.] 

Mr. BACHUS. I thank the chairman. 

Are there any other members who wish to make opening statements? 

Mr. GILLMOR. Mr. Chairman? 

Mr. BACHUS. Mr. Gillmor? 

Mr. GILLMOR. Mr. Chairman, I want to take the opportunity to 

introduce a constituent of mine who will be on the second panel, 

Bill Small from the Fifth District of Ohio. Bill is the President and 

the CEO of First Financial, which is based in Defiance, Ohio. 

Today, he is testifying on behalf of America’s Community Bankers, 

an organization on which he serves as a board member and also 

on several committees. 

Bill Small has also recently served as the President of the Federal Reserve’s Thrift Institutions Advisory Council, and he contributes significantly to our community, working with Defiance College, Defiance YMCA, the Rotary Club, and others. I appreciate his 

service to the district, and I am sure that his comments today will 

be very helpful to this committee in its deliberations. 

Thank you, Mr. Chairman, and I yield back. 

Mr. BACHUS. Thank you, Mr. Gillmor. 

Hearing no other members that wish to make opening statements, at this time I will introduce the first panel. I am going to 

go from my left. 

9

Our first panelist is the Honorable Susan Schmidt Bies, Governor of the U.S. Federal Reserve Board of Governors. I want to 

personally say that since your appointment to head up this at the 

Fed, that I think our relationship, at least our communications, has 

improved, so I commend you for that. 

Mr. Richard M. Riccobono is Acting Director of the Office of 

Thrift Supervision. 

Ms. Julie Williams is Acting Director of the Office of the Comptroller of the Currency. 

And the Honorable Thomas J. Curry is Director of the Federal 

Deposit Insurance Corporation. I want to commend OTS, the OCC, 

and the FDIC for your concerns that you have expressed as to the 

affect that these proposals will have on your member institutions. 

I very much appreciate the focus you have given this. I think you 

have been a large reason why we have not rushed into this headlong and made some great errors. So I commend you. 

At this time, I recognize Governor Bies. We will start with you 

for your opening statements. The opening statements, although we 

say 5 minutes, one or two have mentioned that your opening statement may be 6 or 6 1/2 minutes. We are not going to strictly enforce that 5-minute rule. 

STATEMENT OF HON. SUSAN SCHMIDT BIES, GOVERNOR, U.S. 

FEDERAL RESERVE BOARD OF GOVERNORS 

Ms. BIES. Thank you, Mr. Chairman. Good morning Chairman 

Bachus and Chairman Pryce and members of the Subcommittees. 

It is my pleasure to join my colleagues here today to discuss the 

current status of Basel II in this country. My comments are going 

to be brief, and I ask that my full statement be placed in the 

record. 

The agencies’ joint decision to delay the scheduled mid-year release of the notice of proposed rulemaking for Basel II was prudent 

and necessary. Our most recent study of the potential quantitative 

impact of the proposal, QIS-4, suggested much larger than desirable reductions in capital and a surprisingly wide dispersion in the 

estimates of the risk parameters that are used to determine regulatory capital under the proposal. As responsible regulators, we believe it is appropriate to improve our understanding of these results and to consider what changes might be needed to our proposal before we move forward on the NPR. 

However, delaying the NPR and related documents creates a dilemma. Without them, core and potential opt-in banks do not have 

the blueprints to complete the databases and systems for the regulators to fully assess how banks would operate under Basel II. With 

limited databases and systems, banks provided us in QIS-4 their 

best estimates. We need to learn what we can from reviewing their 

responses, but there are limits to what we can learn as we do this 

review. 

Consequently, we should, as soon as feasible, continue with the 

development of the NPR and related supervisory guidance. These 

documents are essential to the ultimate provision to us of the credible inputs we need to evaluate the effects of Basel II. We hope 

thereafter that we can stay as close as possible to the 2008 start 

date for the so-called transition run. The ability of banks to do so 

10

is one of the questions we propose to ask in the NPR. If evolving 

developments require we delay this schedule, we will of course do 

so and announce it as soon as the decision is made. 

As described in some detail in my statement, the implementation 

process that has been proposed would have banks providing us 

credible inputs based on real databases and systems over at least 

a 3-year period. We know banks’ evolution in these processes is 

proceeding very quickly. A lot can be accomplished in this timeframe. 

For individual banks, implementation can only occur as soon as 

supervisors are satisfied with each bank’s systems and processes. 

If a bank does not meet these standards, they will not be allowed 

to go into Basel II. The delay in the NPR and this implementation 

schedule are fully consistent with the policy the agencies have followed throughout the development of Basel II. We have made 

many changes that incorporate comments that we have received 

and tried to base our decisions based on the best evidence available 

at the time. We have announced that we would not move to final 

implementation until we are confident that Basel II was consistent 

with a safe and sound U.S. banking system. 

Basel II is an important supervisory advance. The current framework is being arbitraged aggressively and provides us with less and 

less reliable measures on which to base a regulatory capital requirement for our largest and most complex banking organizations. 

Our banking system and financial markets are strong and safe 

now, but they were not always so in the past two decades. We need 

now to take the steps to ensure that the current safety and 

strength is extended for our large global banking organizations. 

Members of the subcommittee, the FDIC has underlined the importance of supplementing the risk-based capital requirement of 

Basel II with a minimum leverage ratio and prompt corrective action as part of a prudent supervisory regime. I want to be quite 

clear that the Federal Reserve concurs in the FDIC’s view. We 

need for reasons I have described the risk measurement and risk 

management infrastructure and risk sensitivity of Basel II, but experience suggests that we also need the supplementary assurance 

of a minimum equity to asset base for entities that face the moral 

hazard of the safety net. 

All of us are aware of the concern of thousands of banking organizations that will not be subject to Basel II that they will be 

placed at a competitive disadvantage. The results of QIS-4 have 

only heightened these concerns. The Federal Reserve’s research 

published in our competitive studies has identified competitive impacts in the small business and residential mortgage markets. The 

agencies are as a result developing simple modifications to the current rules that will make them more risk sensitive to address these 

competitive concerns. 

We hope to publish a proposal to amend Basel I for those banks 

that will not be in Basel II at the same time that the Basel II NPR 

is released. In this way, the public can review both proposals, compare them, and give us comments on each, particularly around the 

competitive impacts. Let me make clear that these modifications 

would in no way make such revised current rules substitutes for 

the needed reforms for the sophisticated financial products and 

11

services provided by our large complex internationally active organizations. 

I will be pleased to answer any questions. Thank you. 

[The prepared statement of Hon. Susan Schmidt Bies can be 

found on page 52 in the appendix.] 

Mr. BACHUS. Thank you. 

Now, Director Riccobono. 

STATEMENT OF RICHARD M. RICCOBONO, ACTING DIRECTOR, 

OFFICE OF THRIFT SUPERVISION 

Mr. RICCOBONO. Good morning, Chairman Bachus, Chairman 

Pryce, Chairman Oxley, and Ranking Member Maloney. I want to 

first thank you for holding this hearing on Basel II and for your 

continued interest in this issue. I would ask Chairman Bachus if 

I could submit my written testimony into the record. 

I particularly want to thank you, Chairman Bachus, for your legislative efforts in H.R. 1226. We fully support it, including the provision you have in there regarding OTS’s representation on the 

Basel committee. It is important that OTS’s international role be 

formalized for numerous reasons, not the least of which is the potential impact of Basel II on the institutions and holding companies 

we regulate. 

OTS is experienced in regulating institutions that specialize in 

residential mortgage-related lending, now representing almost 40 

percent of the assets of the entire U.S. banking system. It provides 

us with a unique supervisory perspective. In addition, our experience regulated diverse holding company structures recently recognized by the European Commission when it quoted OTS equivalent 

under the EU’s financial conglomerates directive as another important reason for OTS’s representation on the committee. Although 

we are more than 2 years from its projected implementation, now 

is a good time to update you on our progress and the issues that 

U.S. institutions may face under Basel II. 

We very much support Basel II and are committed to implementing a prudent and sensible framework for it in the U.S., but 

there is much to be done before we are ready to implement it. 

While Basel II provides an opportunity for our largest U.S. institutions to move to a more logical risk-based capital framework, it is 

equally important to identify ways to improve the risk sensitivity 

of Basel I for the thousands of institutions that will remain subject 

to it. These objectives are not mutually exclusive, but rather mutually dependent in order to prevent potential competitive inequalities between Basel II adopters and non-adopters. 

Risk-sensitive capital requirements are as important for community banks as they are for large internationally active institutions. 

Achieving greater risk sensitivity for one part of the banking system and not the whole will create competitive distortions. While 

global regulatory convergence of capital standards is extremely important, we must not ignore its effects and potential impact on 

U.S.-based institutions that are not operating internationally. 

OTS is pleased that an initiative we advocated for years, the socalled ‘‘Basel I rewrite,’’ has ripened into a commitment by all the 

Federal banking agencies to modify Basel I for U.S. institutions not 

adopting Basel II. The goal of this initiative is to achieve greater 

12

risk sensitivity without undue complexity. This can be accomplished by applying more accurate risk weights for a wider range 

of asset buckets and by applying commonly understood criteria for 

assessing the relative risk of various loan types. We strongly support amending Basel I in conjunction with Basel II, but sooner if 

Basel II timeframes are pushed back. 

On the issue of timing, the results of QIS-4 suggest that Basel 

II is very much a work in progress in the U.S. It is appropriate at 

this juncture to ask whether we may be moving too quickly, and 

if so to reassess and determine how to adjust existing timeframes. 

Although implementing a more risk-sensitive capital framework is 

an important objective, we must do so mindful of an equally important objective of doing no harm to our existing banking system. 

Given what we have learned so far from QIS-4, prudential supervision suggests that a longer implementation period may be needed 

to gain the necessary data and confidence we require before implementing such a major change to our capital framework. We believe 

as a matter of good public policy that the Basel II timeframes 

should be viewed as guidelines, not hard targets. 

QIS-4 also did not capture the impact of interest rate risk largely 

because Basel II treats interest rate risk differently than other 

risks. As noted earlier, the banking and thrift industries currently 

have almost 40 percent of their assets in residential mortgages and 

mortgage-related assets. Interest rate risk, especially important for 

mortgage products, must be addressed uniformly with guidance 

from the Federal banking agencies on how to measure and manage 

this risk. 

Any discussion of Basel II is incomplete without a discussion of 

the interrelationship between leveraged and risk-based requirements. Unfortunately, the issue has spawned a substantial amount 

of dialogue about whether there should be a leverage requirement 

at all. OTS does not advocate eliminating a leverage requirement. 

I am going to say that again. OTS does not advocate eliminating 

a leverage requirement. 

However, the current one-size-fits-all approach to a leverage ratio 

runs at cross-purposes with Basel II. Leverage treats all assets on 

the balance sheet identically. It provides too little incentive to manage risk for both very low and very high credit-risk institutions, 

and off-balance sheet activity is untouched by existing leverage requirements. Moreover, a capital framework with a risk-insensitive 

leverage ratio may have the unintended consequence of perversely 

motivating low credit-risk lenders to pursue riskier lending. 

Likewise, layering in a variety of permanent countermeasures 

such as arbitrary floors and multipliers into Basel II to offset capital reductions in low credit-risk portfolios undermines the overarching goal of creating a more risk-sensitive framework. It is critical that we address the leverage requirement and the Basel II 

floors as a complete seamless and integrated time framework. 

We will continue to work with you, the other Federal banking 

agencies, and our colleagues in the international community to ensure that we do not sacrifice safety and soundness for the sake of 

delivering a timely, but potentially flawed capital framework. 

I will be happy to answer any questions that the committees may 

have. Thank you. 

13

[The prepared statement of Richard M. Riccobono can be found 

on page 147 in the appendix.] 

Mr. BACHUS. Thank you. 

Acting Director Williams? 

We appreciate your testimony, Acting Director Riccobono. 

STATEMENT OF JULIE WILLIAMS, ACTING DIRECTOR, OFFICE 

OF THE COMPTROLLER OF THE CURRENCY 

Ms. WILLIAMS. Chairman Bachus, Chairwoman Pryce, Congresswoman Maloney, members of the Subcommittees, thank you for inviting the Office of the Comptroller of the Currency to participate 

in this very timely hearing. 

In my remarks this morning, I will highlight three areas: first, 

where we stand on implementation of the Basel II framework in 

light of the recent results of the fourth quantitative impact study, 

QIS-4; second, our commitment to contemporaneously modernize 

the current domestic capital rules for those banks that will not be 

governed by the Basel II rules; and finally, some thoughts on H.R. 

1226. 

Last year, the U.S. banking agencies undertook a fourth quantitative impact study, QIS-4, with the specific goal of gaining a better understanding—before its adoption—of how Basel II might affect minimum risk-based capital within the U.S. banking industry. 

The agencies recently completed a preliminary analysis of the QIS4 data and certain initial observations became very evident to us. 

In brief, the QIS-4 data evidenced both a material reduction in 

the aggregate minimum required capital for QIS-4 participants and 

a significant dispersion of results across institutions and across 

loan portfolio types. For example, aggregating over the QIS-4 participants, the decrease in effective minimum required capital was 

17 percent, while the median decrease among participants was 26 

percent. Changes in effective minimum required capital for individual institutions ranged from a decrease of 47 percent to an increase of 56 percent. While some dispersion of results in a truly 

more risk-sensitive framework is to be expected, we are not convinced that the wide ranges indicated by QIS-4 can be fully explained by the relative differences in risk among institutions. 

I must pause here to strongly emphasize that the change in what 

we are calling effective minimum required capital represents the 

change in capital required to meet an 8 percent minimum total 

risk-based ratio. It does not reflect that individual institutions in 

fact hold capital in excess of regulatory minimums and, therefore, 

it does not imply that any particular institution would actually 

need to increase its capital in order to be capital—compliant. 

Finally, changes in minimum capital requirements—both increases and decreases—of certain portfolio types, credit cards on 

the one hand and mortgages on the other, significantly exceeded 

our expectations. 

Based on this preliminary assessment of QIS-4 results, the agencies concluded that a delay in the notice of proposed rulemaking 

was the only responsible course of action available to us. For that 

reason on April 29th, we announced that we would not publish a 

proposed rule on the schedule that we had previously forecast. 

14

The obvious question all this raises is, what now? We continue 

to believe in the potential of Basel II to achieve its crucial objectives: improved risk management, supported by significantly greater risk sensitivity in the regulatory capital framework. But, the 

issues surfaced during our preliminary work point to a need to do 

a more complete assessment of the QIS-4 results. This additional 

work is necessary to determine whether the preliminary results reflect actual differences in risk, simply reveal limitations in QIS-4, 

are the product of variations in the stages of bank implementation 

efforts, and/or suggest the need for adjustments to the Basel II 

framework. 

The results of our additional work will tell us much about the 

steps that we need to be taking in order to make Basel II a reality 

for U.S. financial institutions. If we believe that changes in the 

Basel II framework are necessary, we have consistently said that 

we will seek to have those changes made by the Basel Committee. 

I also want to assure you that the U.S. banking agencies recognize that domestic institutions not subject to Basel II-based capital 

requirements, including mid-sized and community banks, have a 

strong interest in the ways in which their products, pricing, and 

business strategies might be affected by implementation of Basel II 

by their competitors. That is why we have undertaken a separate, 

but related, effort to update and modernize the domestic risk-based 

capital rules for those institutions not subject to Basel II. The 

agencies are developing these two capital rulemaking projects in 

tandem to ensure that appropriate risk sensitivity and consideration of competitive effects are considered in each proposal. 

Finally, the Subcommittees have asked for our views on H.R. 

1226. We share the desire of the bill’s sponsors to ensure a strong 

and consistent position among the banking agencies in our approach to Basel II. We also agree that the types of factors listed 

in the bill are very relevant to evaluating the impact of implementing Basel II. However, with the greatest respect, we do not believe that legislation is needed to achieve these results. Since the 

beginning of the process that led to the adoption of the Basel II 

framework, the agencies have worked closely together. While there 

have been differences in views along the way, I believe these different perspectives have, on balance, been constructive. I have confidence that this will continue to be the case. 

Also very relevant here is the fact that the OCC, and I believe 

also the OTS, has designated the Basel II rulemaking as a significant regulatory action for purposes of Executive Order 12866, 

which requires us to prepare a regulatory impact analysis (RIA) for 

OMB review prior to publication of the proposal. The RIA will include an assessment of the costs and benefits of the proposed regulation, and it will address many of the factors that are identified 

in H.R. 1226. 

In closing, let me emphasize three commitments that have been 

and that remain central to our work on the Basel II framework: 

first, an open rulemaking process in which comments are invited 

and considered, good suggestions are heeded, and legitimate concerns are addressed—there is no done deal here; second, a reliable 

quantitative analysis prior to adoption of a rule, through which we 

can assess the likely impact of Basel II on the minimum regulatory 

15

capital requirements of our banks; and finally, a prudent implementation in which we make well reasoned and well understood 

changes to bank capital requirements and incorporate those 

changes with appropriate conservatism. 

Thank you for holding this important hearing, and I look forward 

to answering your questions. 

[The prepared statement of Julie Williams can be found on page 

173 in the appendix.] 

Mr. BACHUS. Thank you. 

Mr. Curry? 

STATEMENT OF THOMAS J. CURRY, DIRECTOR, FEDERAL 

DEPOSIT INSURANCE CORPORATION 

Mr. CURRY. Thank you, Chairmen Bachus and Pryce, and Ranking Member Maloney and members of the subcommittees. I am 

pleased to represent the FDIC at this important hearing. 

Basel II is an effort to tie capital requirements more closely to 

risk and promote a disciplined approach to risk management at our 

largest banks. The FDIC supports these goals and the process of 

implementing a revised capital framework in the United States. 

First, I would like to mention some concerns the FDIC has about 

the results of the recent quantitative impact study, or QIS-4. The 

issues we discuss today may sound sweeping and fundamental, but 

we believe that they can be resolved. Our intention is to work with 

our fellow regulators to address our concerns and to move forward 

expeditiously when this is done. 

The agencies’s review of QIS-4 is not complete. Nevertheless, in 

part because the QIS-4 results are consistent with previous FDIC 

analysis, we have formed some preliminary conclusions. In our 

view, QIS-4 shows excessive reductions in risk-based capital requirements. For half of the 26 banks in the impact study, capital 

requirements fell by more than 26 percent. This is without fully 

factoring in the benefits of credit risk hedging and guarantees that 

are likely to reduce capital requirements significantly more. 

For individual loan types at individual banks, almost half the reductions in capital requirements were in the range of 50 percent 

to 100 percent. Numbers like this do not give us comfort that the 

Basel framework will require capital adequate for the risks of individual activities. 

We are also concerned about what the dispersion of results suggests about the difficulty of applying the framework consistently 

across banks. Capital requirements in Basel II are very sensitive 

to inputs. Achieving consistency in Basel II depends on the idea 

that best practices and best data will lead to convergence in the 

capital treatment of similar loan portfolios across banks. At 

present, however, at least as indicated by QIS-4, there is little commonality in the approaches the various banks used to estimate 

their risk inputs. 

The FDIC has stated on many occasions that there is a continued 

need for a leverage ratio. I would add at this point that the QIS4 results suggest to us that our U.S. leverage requirements will be 

even more important under Basel II. The FDIC can support moving 

forward with this new framework only because of the existence of 

the leverage-based component of U.S. capital regulation. 

16

We also have a concern about the potential competitive effects of 

the new framework. If QIS-4 is representative of capital requirements going forward under Basel II, the competitive ramifications 

for community banks and large non-adopting banks could, in our 

view, be profound. If Basel II is implemented unchanged, the only 

option for mitigating these competitive inequities would appear to 

be a substantial reduction in capital requirements for all insured 

institutions. 

All of these issues suggest to us that thought needs to be given 

to finding ways to implement this new framework in a manner that 

produces results that are less extreme and more consistently applicable across banks. 

With respect to the issue of capital requirements for operational 

risk, I will make one point. Because Basel II’s advance measurement approach, or AMA, is complex and expensive, large banking 

organizations understandably do not want to implement it at each 

and every insured subsidiary. The FDIC believes, however, that 

every insured institution should maintain an adequate level of capital, a point of view that, strictly speaking, implies the need for 

every insured bank to have its own AMA. 

In resolving these conflicting goals, we are inclined to seek ways 

of moderating the AMA, rather than compromising the important 

responsibilities of insured banks and their boards. For that reason, 

we will continue to work with our fellow regulators to explore simpler, less burdensome approaches for insured institutions to meet 

their requirements for operational risk within this new framework. 

In summary, for Basel II to be successful the FDIC believes we 

must preserve a set of straightforward minimum capital requirements to complement Basel II, maintain competitive equity among 

large and small domestic and international institutions, and find 

ways to achieve results under Basel II that are less extreme and 

more consistently applicable across banks. 

The FDIC, in cooperation with the other banking agencies, will 

proceed in an appropriately deliberative manner and with full consideration of the comments of all interested parties. We believe 

these goals can be achieved. 

This concludes my remarks. I will be happy to answer any questions from the committee. 

[The prepared statement of Hon. Thomas J. Curry can be found 

on page 103 in the appendix.] 

Mr. BACHUS. Thank you. 

Governor Bies, let me ask you the first question. I want to go 

back to one reason that we are having the hearing today, and that 

is an article I read back in January in the American Banker. What 

it said there, it referred to a study that the Fed had done. This 

study says that residential mortgage portfolio capital levels will 

drop so significantly at the 20 or so U.S. banks that adopt Basel 

II, that they will hold a major competitive advantage over all other 

U.S. banks. 

Now we know that that paper was never published. It was prepared by two economists, one of which had worked for the Fed for 

20 years, who no longer works there. They are on our second panel. 

When I read that, it was everything that the other regulators had 

been saying. It was everything that regional banks and others had 

17

been saying to us, but it was counter to what the Fed’s position 

was. It was counter to what Mr. Ferguson was saying. So I immediately wondered why the paper was never published, because I am 

very concerned about people being able to speak out without any 

fear of expressing a different opinion from someone else. 

Since that time, I have read that even one of the Governors of 

the Federal Reserve in St. Louis expressed the same concerns and 

said that he believed that there was a good chance there would be 

a competitive advantage, a major competitive advantage for the 

large banks. There have been others that have expressed this opinion, including other regulators. 

And then you all took another look at it. You did not publish the 

first report. It never was published by the Fed. And now you have 

come out with a second report which basically appears to be the opposite of the first report, that says Basel II will not tilt the mortgage field. 

Can you give me some background on maybe why, number one, 

the Fed decided not to publish that paper? Number two, I know the 

two gentlemen have left, and I assume, I am sure they left voluntarily, but why would economists that had been there 20 years 

come up with one conclusion, and then you get another group of 

economists at the Fed and they come up with a different conclusion? Did the second report maybe conclude some things starting 

out that the first one did not? 

Ms. BIES. Mr. Chairman, I think you know that if you get in a 

room with several economists, you will get very different perspectives. We even get it when we talk about where interest rates may 

go. The one criterion that the Fed sets for all the research is the 

quality of the research. As the paper was initially completed, there 

were some concerns about the qualitative aspects of the research 

itself, not the conclusion. 

I want to make it clear that we encourage information at the Fed 

because of the ability to really understand factually what is happening. It is something we rely on whether we are dealing with 

monetary policy, bank supervision, or consumer affairs. We look at 

it all, but we want strong research. We encourage it not only at the 

Board, but each of the Federal Reserve banks. That is why we 

allow the Federal Reserve banks to have their own opinions. The 

only standard we ask is quality research. 

Mr. BACHUS. Let me say this, I am not saying that that is why 

they left. I have no reason to believe that. I am just saying that 

they concluded one thing and then your next study another, and 

they were experienced economists, well respected. And then a different group of economist at the Fed concluded a diametrically different conclusion. Doesn’t that bother you or disturb you that your 

own economists cannot even agree, that some of your economist 

have said, some that have been there 20 years in fact? 

I guess it was the two that the Federal Reserve asked to do this 

report. That would lead me to believe you felt maybe, or someone 

at the Fed felt they were the most qualified at the Fed to do it. 

They did it and concluded that it would be a major, major competitive advantage for the 20 largest internationally active banks over 

all our other banks. We are talking about residential mortgages 

here, which could have a tremendous impact on every American 

18

who has a mortgage or wishes to buy a home. And then that was 

not published. Why wasn’t it published? 

Ms. BIES. Let me get to the bottom line of the conclusions of the 

research. 

Mr. BACHUS. Sure. 

Ms. BIES. I think here what we need to understand is what the 

questions were that were being asked. When we talk about the impact on most mortgages in the United States, most of those mortgages are securitized today. They are underwritten for credit based 

on Fannie and Freddie standards. 

Mr. BACHUS. But you know, there are proposals to change that, 

as Mr. Frank I think mentioned. So you are assuming that things 

are going to go on as they are at the GSEs when there is major 

legislation up here that could change that? 

Ms. BIES. I guess I want to make a distinction there. I am talking about the securitization of the mortgages, not whether Fannie 

and Freddie choose to buy back those mortgages that have been 

securitized. That is a separate issue. 

Mr. BACHUS. But if we put a cap on their capital, which the 

Treasury for one is proposing that we do that, that would affect 

whether they bought the——

Ms. BIES. Right. But to the extent they have to fund it all, it still 

would influence rates in a similar way, and that is a separate 

issue. 

I am trying to get at the results of this research. To the extent 

that the loans are still going to be securitized, the loans that are 

being securitized on the standard mortgages are priced in markets 

today. There will be little impact of that on financial institutions. 

The real differentiation is going to be the choice that institutions 

make to hold whole loans on their books or to hold mortgages that 

are not conforming on their books. 

As you are well aware in the last couple of years, as the housing 

industry has had strong price appreciation, consumers have refinanced, and we have seen evolving structures of various types of 

mortgages. Some of these are riskier than traditional mortgages. 

Others are just as safe. They are just bigger than conforming loan 

sizes are. For the portfolio loans, the loans institutions would like 

to hold on their books, we do need to make changes to Basel I or 

we would end up with an imbalance because the 1988 Accord overestimated the kind of capital you need around traditional well-underwritten mortgages. 

Mr. BACHUS. All right. Let me say this. I now agree with you, 

but you cannot assume in a study that you are going to make those 

changes in Basel I and know what that effect is going to have when 

you have not even made the changes in Basel I. What you are saying is, if we change Basel I, we probably will not have this competitive disadvantage. We have not changed Basel I. Do you agree that 

maybe we ought to change that before we make an assumption? 

Your latest economists, they said that basically these small banks 

could reposition their portfolios. Or what you are saying is that we 

are going to change Basel I so they will not be at a disadvantage. 

Ms. BIES. What I am saying, is for the loans that are put in the 

portfolio that will end up being a competitive disadvantage for the 

safest mortgages because the big institutions already are taking 

19

those loans off their books, they are already able to get around the 

existing capital limitations that Basel I puts on them. For smaller 

banks, it is more difficult for them. They do not originate enough 

deal flow to pool these mortgages effectively. So they very often 

keep mortgages on their books, especially non-conforming. That is 

the issue that we are trying to deal with in terms of capital on the 

books. 

Mr. BACHUS. I guess what I am saying, this latest Fed study 

which contradicted the first did not say in there, now, we are going 

to change the requirements in Basel I and it will allow these small 

banks to not be at a competitive disadvantage. It assumes something without saying it. 

Ms. BIES. It was really focusing on the impact of the securitized 

conforming mortgages. What I am saying is that it is a broader 

question. There is more variety of mortgages today and I think by 

looking at both of these aspects, we can understand that banks are 

trying to innovate to serve their various customer needs. And as 

they innovate we need to make sure that the risk framework, 

whether it is the banks in Basel II or the banks in Basel I amended that are going to have the flexibility. If there are riskier loans, 

capital should go up. If they are less risky, it should come down, 

for both sets of banks. 

Mr. BACHUS. I guess what I am saying, and my time is over, but 

you also assume in this second study that the GSEs and the way 

they do business is going to remain the same. 

Ms. BIES. We made that assumption because it is unclear exactly 

how they would change. 

Mr. BACHUS. That is right, but that is a pretty big assumption. 

Ms. BIES. It is a big assumption. 

Mr. BACHUS. Thank you. 

Ms. Maloney? 

Mrs. MALONEY. Thank you. 

Following up on the chairman’s questions, Honorable Ms. Bies, 

on page seven of your testimony you note the heavy investment in 

systems and processes that U.S. Basel II banks have been making. 

You express concern that these banks not be placed at a competitive disadvantage vis-a-vis a foreign bank by a delay in the rulemaking. 

But in light of that recognition and following up on the chairman’s points, how can the Fed argue that banks which compete 

with non-banks or smaller non-Basel II banks will not also be at 

a disadvantage because they would hold more capital than their 

competitors? 

Ms. BIES. I think I want to differentiate here between what we 

are trying to do on the international front and the domestic front. 

In the U.S., we have chosen to only mandate the very large complex organizations to go into the advanced approaches to Basel II. 

We did that because we are concerned that for these complex organizations, the existing capital framework is so simple because it 

ignores so much of the risk that is off the books, that we need to 

get something that reflects the evolution they have. They keep inventing new types of financial instruments, new deal structures. 

Items are off the books so they are not visible in the traditional 

capital framework. 

20

As they keep evolving in that way, we need to make sure that 

capital reflects risk around the way they are managing their product lines and their customer exposures. We do not expect that any 

mid-size or small bank would necessarily make these investments 

in these sophisticated risk tools. But we do expect today, under our 

supervisory framework of safety and soundness, that any sophisticated bank that deals with these tools has already in place a strong 

risk management framework. So depending on the large banks that 

you are describing, for many of them they are in the process of extending databases, but they already have a framework that looks 

at risk in a very sophisticated way. 

The formula, for example, that you mentioned that is posted here 

is one of those aspects on how loan pools are put together to look 

at different risks in different branches. We actually proposed at one 

point a more simplified version of that formula, and the banking 

industry came back and said no, that they felt it was not reflective 

enough of risk and wanted us to move to this version of the formula because it better reflected the different risk aspects that are 

used as loans are being securitized. 

The fact that these organizations are engaging in this sophisticated activity and we already are looking at them and expecting 

them to have systems in place to understand various aspects of 

risk, it is an easier evolution for Basel II for these organizations 

than institutions who would not undertake these sophisticated 

transactions. That is why we have to keep a very simple framework 

for the banks that are not in Basel II, but make sure that an answer is comparable on the risk that results. 

Mrs. MALONEY. But these systems that they have put in place, 

according to this QIS-4, are flawed. They are coming forward with 

very different risk and very different capital requirements, and no 

explanation of why similar institutions have such large different 

results. So it seems that if we keep going forward, in a sense, you 

are encouraging a flawed system that would aggregate the competitive problems that we were suggested in the QIS-4 study. 

Ms. BIES. I agree that all of the results in QIS-4 for every bank 

are flawed in the sense that today no U.S. bank would qualify for 

adoption of Basel II. None of us would qualify any of these banks. 

Remember what the QIS process was designed to do. This is the 

fourth one we have done. We did these periodically so banks who 

are thinking about going to Basel II could use it as a milestone to 

sort of say how are we progressing and what are the issues we 

need to be focused on. We could use it as a check for whether the 

framework had issues we had to deal with. 

If you look at individual banks, and we are still doing this, one 

of the things you find is that, for example, some banks did not have 

a process in place for certain portfolios or loan types or risk elements. As a result, it is zero. Well, if you put in a zero because you 

did not complete that part of the exercise, you are adding in a zero. 

And we know that clearly is not the answer. 

If we look at banks that we would expect similar results, one of 

the issues we have is their database limitations. Some do not go 

back very far. We have been very lucky in this country in the last 

few years. Credit quality has been extraordinarily sound. We are 

expecting when this gets done that the databases for credit risk go 

21

through a credit cycle. Right now, the databases only have the good 

years, and when you only have the good years, you are necessarily 

going to have a lot less capital than if your database includes the 

bad years in a credit cycle, and that requires more credit. 

Most of the banks in this process did not have that full cycle of 

data underlying their loans, and that is another reason. That is 

what we are trying to do, is to separate out the reasons for the differences and begin to focus on where are they in their development 

process and where are we needing to make changes in the existing 

framework. 

Mrs. MALONEY. Then why did banks with similar portfolios end 

up with different results? You say that the database had limits. Is 

that the only reason? What about different applications? Why did 

it end up with such different results? 

I would beg the chairman to allow other members of the panel 

to answer because that is the basis of this hearing. It is why did 

we get such different results with similar banks and similar portfolios? What is the explanation? 

Ms. BIES. Again, let me just make one other point. This is why 

we are trying to do this delay to find out the facts. We do not have 

all the answers yet. I am saying that the initial results, banks we 

thought should be the same, for example, there are parameters and 

models that are different. 

One of the requirements we say you have to look at what in a 

downturn stress situation of credit losses, what would your estimate be. Some banks have not put together any methodology to get 

to it, and actually there is nothing there for that effect. If banks 

are having difficulty coming up with that, then that is a signal to 

us as regulators that we may have to mandate an assumption to 

get everybody who has similar credit portfolios to use the same parameters in their models. 

Mrs. MALONEY. Okay. 

Would anyone else like to comment on this? Ms. Williams? 

Ms. WILLIAMS. Congresswoman, the basic answer to your question of why there are these differences is that we do not know yet. 

That is exactly what we are drilling down into right now. That is 

what this whole QIS-4 process is about—enabling us to understand 

better how these processes work. So I would like to characterize 

the QIS-4 process and the results of the QIS-4 process as a good 

thing. This is showing that the process that the agencies have in 

place to work through the implementation of Basel II is proceeding 

in a careful and judicious way. We decided we need to slow down 

here and understand better the numbers that we have, and that 

is what we are going to do. 

Mrs. MALONEY. Thank you. 

My time is up. Thank you, Mr. Chairman. 

Mr. BACHUS. Thank you. 

Chairman Pryce, I want to commend you on your preparation for 

this hearing and your support. 

Ms. PRYCE. Thank you. 

I appreciate this opportunity, and I want to thank the panel for 

helping us understand where the regulators believe we are in this 

process. I believe we are at a pretty critical stage. There are obviously some significant problems with the implementation of Basel 

22

II, but there is a possibility of a competitive disadvantage for U.S. 

banks in the international marketplace if there are not the appropriate changes currently made in the capital requirements. 

My question to you all is, does it make any sense at all in ordering that the noncontroversial parts of the accord be implemented 

sooner? Then the regulators can go back and work on the remaining provisions that are more controversial for future implementation. You know, just kind of pick the low-hanging fruit, get started, 

get up and running, and then work out all the details and not have 

to have the perfect final product before we can see some advancement. Has there been any discussion of that? If it is a bad idea, 

can you tell me why, any of you? 

Ms. BIES. Let me start. Right now as we look at QIS-4, and as 

we move forward in the Basel II process, we are going to be looking 

at those kinds of issues. Clearly, we are running into different 

issues around different aspects of risk. The one example I just 

mentioned about what do you do with a downturn stress situation, 

a severe recession. Because we did not capture the kind of data we 

want in these models back in the 1980s, the last time we had such 

a time, we may need to simplify that and put in a temporary assumption until we have used these models through a crisis scenario. In that sense, it is simplifying and we can get to a decision 

relatively quickly. 

Another example is the operational risk information. We have 

been collecting data from the banks that are participating in the 

process, and we are putting together at the Federal Reserve Bank 

of Boston a significant database on operational risk that has millions of entries to date. This is one way to develop deep enough 

databases that can either be shared with or amony banks, so they 

do not have to incur all the costs on their own or as a basis simplify or modify the assumptions. We could look at that alternative. 

We are really trying to think outside the box and respond to the 

industry and also be sure that the framework is sound in a riskfocused approach, and we will be considering those alternatives as 

we go ahead. I think the one thing we need to be careful about 

doing it piecemeal is that we really think through what the implications could be in different product markets and the competitive 

impacts in the United States. We need to think that through as we 

go forward. 

Ms. PRYCE. Anybody else? 

Ms. WILLIAMS. I’d like to offer a complementary perspective on 

this. The U.S. regulators chose to implement the advanced approaches for Basel II because we felt that that ultimately was the 

best way to end up having a truly risk-sensitive capital regime. It 

is very hard to pull apart pieces of an advanced IRB approach or 

an advanced approach for op-risk and do a partial implementation. 

What is possible in moving ahead with the implementation process is to make sure that you have safety nets, stopgaps, prudential 

provisions in place so that you are comfortable with the implementation process as it goes forward. Those are some of the things that 

Governor Bies was mentioning as possibilities. What we hope we 

will discover as a result of our deeper analysis of the QIS-4 data 

is which of those ideas, and maybe others, make the most sense to 

use based on the circumstances. 

23

Ms. PRYCE. I hope, because we are moving the timeline again, 

advancing it, and so I hope that some good comes of this, that perhaps it will advance some of this as opposed to postponing it. 

Let me change gears real quickly. I would like to talk about the 

competitive impact on U.S. financial services firms. Last June, 

there was a hearing on private sector perspectives. The subcommittee received testimony that a number of large U.S. security 

firms are going to be subject to Basel II through registration with 

the SEC, pursuant to a new regulatory framework for consolidated 

supervised entities. 

Are you all working with your colleagues at the SEC to ensure 

an equitable application of Basel II as applied to those firms? Is 

the goal to apply Basel II with due recognition of the differences 

between banks and securities firms? Who would like to field that 

one? 

Ms. WILLIAMS. There is coordination among the domestic regulators. There is also coordination in the international arena with 

the international securities regulators and how their implementation of Basel II intersects with the bank regulators’ implementation. So yes, there is coordination. 

Ms. BIES. Let me just make you aware that as part of what Ms. 

Williams just mentioned, the Basel Banking Committee and 

IOSCO, which is the equivalent, the International Association of 

Securities Regulators, of which the SEC is a member, just published a few weeks ago a regulatory capital framework that is riskbased for what we call trading book assets, which is the biggest 

part of securities firms’ balance sheets. 

The idea is that we will end up with a common risk framework 

between both securities and banking regulators, not only in the 

U.S., but internationally. Those comments are due at the end of 

this month. It will take us a while to look at it. Clearly, what we 

are going to learn from that, we will also incorporate into the NPR 

and Basel II going forward. 

The fact that this being done on an international basis I think 

is another signal that we are trying to make sure that similar risks 

are treated in the same way as we can for risk-based capital purposes no matter what the charter of the organization may be. So 

we feel that we are making much more progress along those lines, 

and this new proposal that was jointly issued by both IOSCO and 

the Basel Banking Committee I think is good testament that we 

are working together. There are other aspects of coordination that 

we are still working through, but this will be the meat of what 

needs to happen to go forward. 

Ms. PRYCE. Thank you. 

My time has expired. I want to thank the panel once again, and 

especially thank the chairman for holding this important hearing. 

Thank you. 

Mr. BACHUS. Thank you, Chairman Pryce. 

At this time, Mr. Ford? 

Mr. FORD. Mr. Chairman, thank you. 

And welcome again to the panel. I am sorry that I was late arriving. 

I wanted to especially extend a welcome and even a belated 

happy birthday wish to Governor Bies, who hails a good part of her 

24

life from my home city of Memphis. I am delighted to see you and 

welcome you and thank you for your enlightened insight in remarks today. 

I know that you have been introduced already, and I hesitate to 

say, but I do my banking at her bank, at her former employer 

where she was a long-time Executive Vice President for Risk Management and held a variety of titles at the bank. She is widely regarded and thought of back home. As we can all deduce from her 

testimony today, we can all see why. 

I appreciate your emphasis, Governor Bies, on the quality of research and your willingness to move at a pace and speed that allows us to get all the facts on the table. I was interested also in 

hearing the answer to Chairwoman Pryce’s question as well. I 

think you put some of it in perspective for all of us. 

My question would really be directed to Director Curry, if I 

could. I know that in your testimony, Director, you mention that 

the FDIC has some concerns about the lack of accounting in Basel 

II’s accounting for emerging business lines. I am just curious to 

know if you would elaborate on how great a risk you think this 

poses to the banking system and to the implementation of Basel requirements going forward. 

Mr. CURRY. Our concern is when you look at some of the results 

of QIS-4, particularly with respect to home equity lines of credit, 

that there have been changes in the marketplace in terms that the 

product itself and some of the risks behind it, that the capital levels be representative of those risks. The home equity lines is an example, but there are additional products being developed in a very 

dynamic banking industry, and our concern is that those measurements reflect those risks. 

Mr. FORD. We had, Governor Bies, not long ago before the committee, through Chairman Bachus’s leadership, a hearing on Check 

21 and the impact that has on community banks. The head of the 

Independent Community Bankers Association is from Dyersburg, 

Tennessee, David Hayes. He came on behalf of obviously his association to express their concerns. They were here, and have been 

here the last 2 days, and even expressed some concerns about this 

as well, knowing that you were coming before the committee. 

So I am pleased to hear your remarks and even others, and I 

hope that the committee will take into consideration all that has 

been said and whatever we do to act, that we act in a way that 

will not impact negatively the obvious kind of deliberate effort that 

you have underway. 

I would be remiss if I did not give you an opportunity. I know 

you have had the chance to kind of dominate the talking here on 

the panel, but it is my 5 minutes so I can do what I want with it. 

You have a good colleague with Laricke Blanchard. He is from 

Memphis also, with the Fed Reserve Board. 

But I would love to hear your response to Curry. That is FDIC 

work, but you have had your vantage point on this issue. It has 

been pretty varied like most of your colleagues as Governors. How 

do you respond and how would you react to that question as well? 

Ms. BIES. I agree with Director Curry in terms that it will be a 

challenge to look at any new product initiative. We will have to determine how and when that gets incorporated into an individual 

25

bank’s capital requirements. As safety and soundness regulators, 

we already are looking at new product introduction processes, and 

we require banks today, if they enter into, say, a new loan product, 

they have to today account for credit risk. We would expect that 

they price for that credit risk. We would continue to give guidance 

on the safety and soundness aspect of these. 

I think one of the reasons for the concern for the banks that put 

mortgage loans, for example, in their portfolio is they are stretching and putting the higher-risk loans in the portfolio because the 

capital requirement was placed too high for the traditional conventional 30-year fixed rate mortgages. But stretching to take on 

riskier loans may make the current capital requirement under 

Basel I too low. That is one of the challenges we have with any new 

product is how do you make that determination as to the appropriate level of risk. 

We also know that as banks merge they are going to have conversions going on where they standardize products, get their systems in conformance. Again, it will be a combination of safety and 

soundness reviews and potentially this is where we can use some 

of our discretion as regulators to put a qualitative amount in Pillar 

2 if necessary around risk. 

So I think we have a lot of tools. We just have to realize that 

all of this risk framework is not precise because you are looking 

forward using historic data. Any model in that sense has got some 

limitations. But we need to make sure that if people are putting 

long-term risk on their books or securitizing long-term exposures, 

that that is reflected in their capital and not just the moment in 

time. So we will have this issue with both Basel I and Basel II. 

Mr. FORD. Thank you. 

Mr. Chairman, I know my time is up. Thank you. 

Mr. BACHUS. Thank you. 

I would like to say that Representative Ford and Representative 

Biggert, who is next in questioning, were both original cosponsors 

of the legislation that we have today, H.R. 1226, which expresses 

our concerns about some of what we are hearing today, and I think 

substantiates the wisdom of that legislation. I want to commend 

both Representative Ford and Representative Biggert as original 

cosponsors and recognize the lady from Illinois at this time. 

Mrs. BIGGERT. Thank you very much, Mr. Chairman. 

Thank you, Mr. Pearce, for yielding to me. 

Let me start by saying that I am concerned about the state of 

play. In your testimonies, saying that you as the supervisory community, it sounds like from your testimonies that you could be comfortable with the variances in QIS-4 if that variance were driven 

by portfolio risk rather than model differences. Could someone explain to me what is the difference between these two choices, since 

models define portfolio risk? 

Somebody want to take a chance? 

Ms. BIES. I will answer your question. The models that banks are 

using right now are, and let me start by saying we are still getting 

this information, but they are in different stages of development. 

What we are trying to understand is if one bank has 30-year conventional mortgages, say, on their books and they are modeling 

credit risk, and another bank has the identical kind of credit qualVerDate 0ct 09 2002 14:39 Jan 11, 2006 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 G:\DOCS\109.27 RODNEY
26

ity, same kind of mortgages, the model that they are running, does 

it make different assumptions; does it have different parameters; 

is the database shorter versus longer? One may include data all the 

way back to the 1980s or throw in proxies for the housing losses 

that occurred in the oil patch, say, in Oklahoma and Texas in the 

1980s as stress scenarios. 

The other bank could be saying, well, all I have in my database 

is the last 2 years, and credit losses are very, very low. If you do 

not include the extreme events in your database, you can end up 

with different answers, even though the loan quality is the same. 

That is because the framework of risk-based capital looks at the extreme events. In other words, you assume that normalized losses 

and charge-offs banks should be able to cover through normal operating earnings every day, every month, every quarter. 

What you need capital for, and what we as regulators are focused 

so much on, is do you have enough capital to get you through the 

stress periods, the downturn periods, the really rough times? We 

worry about it as bank supervisors since that is when you call on 

capital to absorb losses. 

So if your database does not include those extreme events, you 

can end up with a different answer. Obviously from the Federal Reserve’s perspective, as a central bank, we worry about systemic 

risk. If everybody leaves out those extreme events, then there are 

implications that the banking system may not have enough capital 

in tough periods, and additional measures may be needed to get 

the economy turned around if we do not have a healthy banking 

system in a recession. 

So that is an example of even with the same kind of quality of 

the loan portfolio and you could end up with a different answer if 

you do not have similar information going into the models. 

Mrs. BIGGERT. So do you want variance and risk sensitivity in 

the same capital framework? 

Ms. BIES. We want to be able to measure risk in a similar way 

across the banks. One of the challenges that we have today is that 

in Basel I we just look at mortgages from a very simple framework, 

or commercial loans from a simple framework, when we know individual borrowers or the facilities structure for individual loans to 

the same borrower expose the institution to very different kinds of 

risk. If we have the same number, what is in effect happening is 

banks to cover that capital will take on higher and higher risk in 

order to leverage it more, which adds systemic risk to the banking 

industry. 

Mrs. BIGGERT. Then how do you know whether you have crossed 

the line into micromanaging credit decisions and eliminating risk 

altogether? 

Ms. BIES. We will not eliminate risk altogether and realize that 

the term ‘‘risk management’’ is chosen for a specific reason. We are 

not telling banks to minimize risk, avoid risk. We are saying whatever risk you choose to take, you need to manage it well. These 

models that the banks are building should reflect their risk appetite, their ability to manage that risk, and the controls they have 

to make sure the risks they thought they were accepting, they 

have. 

27

So it is really targeted around their ability to manage risk. We 

are not micromanaging. We just want to make sure whatever they 

are choosing to do, that the risk management is appropriate. That 

is one of the reasons for the smaller banks; we do not need to build 

these sophisticated structures. They are into much simpler products. More of their products are on the balance sheet, so they are 

easier to see and visible to readers of financial statements and to 

examiners. It is the sophisticated instruments where it is harder 

to understand the risk that we are requiring a stronger risk management process of which capital is one piece. 

Mrs. BIGGERT. There is an old saying that you learn by your mistakes. It sounds like the market should not be permitted to make 

mistakes. 

Ms. BIES. No, the market is going to make mistakes. Individual 

institutions will make mistakes. Again, when you look at models, 

the one thing that worries us all is what have you not put in the 

model that could really affect you. That is why I think for us to 

be good supervisors, the capital framework has got to be part of the 

supervisory process. We can use supervisory processes to ask questions and check ourselves to see what is the model missing. We can 

overlay the two and put another mitigating control for risk exposure in there through the supervisory process. 

You cannot really have good risk management processes in total 

by only using risk-based capital. You have to have good risk management and supervision with it to try to minimize the risk of some 

severe unexpected event happening, but that does not say we can 

always avoid it. There are always going to be surprises. 

Mrs. BIGGERT. So what you really have to do, then, is tweak all 

the various assumptions and parameters in the complex formula. 

Will you do that in Basel I plus II? 

Ms. BIES. We are in the process of drafting this, and I will let 

some other folks talk about Basel I, but we would expect that we 

would do the same thing, but do it in a very simple way, base it 

off the call report the banks use today and not create the need to 

invest in sophisticated models for the banks that do not have sophisticated products like the big international banks in Basel II. 

Mrs. BIGGERT. Okay. Just to go back to the first part of the question about the variance driven by portfolio risk rather than the 

model differences, it sounds like it would be the portfolio risk, 

would be the choice. 

Ms. BIES. If everything was done the way we would perfectly expect it, if you looked at the risk-based capital of two institutions 

and one was more than another, you could say that that institution 

had either riskier exposures or a larger amount of the same exposure. In total, their risk would be bigger, but it could come from 

either way. 

Mrs. BIGGERT. Okay. Thank you. 

Thank you, Mr. Chairman. 

Mr. LEACH. [Presiding.] Thank you, gentlelady. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Chairman Leach. 

Governor Bies, you talked about Basel I rules and Basel I(A), I 

guess, in between. Do you have sufficient resources to work on both 

proposals simultaneously? That is, the interim effort, as we proceed 

28

toward Basel II, are you in a position to handle both of those at 

the same time? 

Ms. BIES. We are in a position to handle both at the same time, 

because I think it is important to implement both of these together. 

We have people that are assigned special responsibilities under 

each one, but the dialogue needs to happen among all the staff and 

Governors involved in this process because we are dealing with 

similar issues for both amending Basel I and developing Basel II. 

We need to constantly have a touchstone between the two to make 

sure that what we are moving forward is going to be consistent and 

deal with some of the issues that this committee has already 

raised. 

Our staff back here may feel that they do not have enough resources. We are adding staff if we feel it is needed, but we feel comfortable that we can make the timeframe in terms of gathering information to support our decision-making. 

Mr. OXLEY. That is encouraging. The leverage ratio is a one-sizefits-all approach to capital. It treats all assets on the balance sheet 

essentially identically. It sounds to me like to be the opposite of the 

approach envisioned under Basel II. Is that a correct assessment? 

Mr. RICCOBONO. It is. The problem, as I stated in my testimony, 

Chairman Oxley, was what we have done is leverage ratios are extremely important, and no one would suggest that we should not 

have it in the Basel II capital framework. But the problem is the 

leverage ratio that we currently have in place is in fact compatible 

and exists as a safety net or a fuse for the rules that we currently 

have in place under Basel I. All that is being suggested, although 

forcefully recently, is the thought that if we are going to move forward with Basel II, we need updating in our approach to capital, 

and we need to think about including there an update of the safeguards with respect to capital. 

You just cannot use the fuses that we put in place for a system 

that was much less, 115-volt system when we move to 120-volt system. We need something more like circuit breakers, than old-fashioned fuses. That is really what the problem is with the leverage 

ratio. We can do some serious damage to our institutions by encouraging our lowest credit-risk institutions, our most conservatively invested institutions, encourage them to take more risk 

simply to take advantage or maximize the fact that they are going 

to be required under an old existing leverage ratio to hold more 

capital than the Basel II approach. 

If their information is sufficient and robust, it says they can hold 

less. Well, we should not then require a greater amount of capital 

that they would have to then manage to. It makes no sense to put 

that in place. So we think that a risk-sensitive leverage requirement is necessary in a risk-sensitive capital environment. 

Mr. OXLEY. Do we have agreement on that with the rest of the 

regulators? 

Mr. CURRY. Chairman Oxley, from the FDIC’s standpoint, it is 

critically important that we have a valid, functioning leverage 

ratio. When we talk about questions about the accuracy of models, 

where we are dealing with the Federal safety net, particularly the 

deposit insurance aspects of it, we think it is critically important 

29

to have that cushion of the leverage ratio, notwithstanding the 

state of art in terms of credit risk management. 

We would point especially to the history of the financial system 

in the United States, the S&L bailout, the issues with long-term 

capital management as examples of where if there are errors in 

models, there are significant consequences, and we need to take a 

conservative approach. 

Ms. WILLIAMS. Mr. Chairman, I think that we feel that it is a 

tremendous undertaking to implement Basel II. The leverage ratio 

is not on the table. 

Mr. OXLEY. I am sorry. What was the last part? 

Ms. WILLIAMS. The leverage ratio is not on the table. 

Mr. OXLEY. Any response? 

Mr. RICCOBONO. Yes, I just think it has to be on the table. We 

cannot go forward with Basel II unless we figure out how we are 

going to continue, if that is where some of us are, that we are just 

going to continue with the existing leverage requirement, and not 

broaden those consistent with the modernization of the capital 

framework. It is not going to work. We are going to have unintended consequences that when we finally figure out what we have 

done, it will be too late. 

Mr. OXLEY. Governor Bies? 

Ms. BIES. Chairman Oxley, I think our perspective on the leverage ratio is that today’s leverage ratio really is not reflective of risk 

because institutions have evolved. It is based on the balance-sheet 

exposures as risk off the books. But I think we would support the 

OCC’s position that we have a long way to go along Basel II. We 

ought to leave our one anchor there in place, especially in terms 

of prioritization of the work we do. 

The full impact of Basel II does not go into effect anyway under 

today’s timeframe until 2010. We will have plenty of time when the 

banks are further along on the adoption to come back and look at 

how, if we do want to change the leverage ratio, how would we do 

it, but I think it is premature today to start that dialogue. 

Mr. RICCOBONO. This needs to all be done before we set sail. We 

cannot set out for open waters and decide we are going to then determine whether the vessel is seaworthy. That is I think unacceptable. 

Mr. OXLEY. So the disagreement continues, basically, between 

the two regulators. 

I yield back. 

Mr. LEACH. Thank you, Mr. Chairman. 

Let me just ask Mr. Pearce a question. You are up next, sir. You 

can start now, or if you would rather wait until after the vote, it 

is up to you. You will have about 4 minutes now, but after the vote 

you would have a bit longer time. What is your preference? Fine. 

Mr. Pearce, you are recognized. 

Mr. PEARCE. Thank you. 

Ms. Williams, you might not be the best one to answer. I am sort 

of lost, but we have heard testimony about different risk management tools. Give me a short list of risk management tools that are 

being used to help banks. If not, if someone else could give me a 

better answer? 

Ms. WILLIAMS. Congressman, banks use a variety of——

30

Mr. PEARCE. Just a short list. 

Ms. WILLIAMS. They look at their past experiences with different 

types of credit to try to identify where exposures can arise. With 

respect to particular types of loans, they look at factors that are 

risk factors for particular types of borrowers. In the consumer area, 

there are very, very sophisticated risk factors that are used in connection with credit scoring for retail type loans. In the wholesale 

arena, there are databases of the performance of different types of 

loans and different types of obligors that banks will look at in order 

to try to identify risk factors. 

Mr. PEARCE. Thank you. 

Governor Bies, as near as I can summarize, we have the question 

of international competition and the question of domestic competition, and we have the question of national economic strength and 

international economic strength. Of those, which would be the 

highest priority in your mind when trying to solve the questions in 

front of us about Basel II? 

Ms. BIES. Speaking for myself, I think the most important thing 

is that we are comfortable that banks in the United States, whether this is their home country or foreign banks operating in the 

United States, have enough capital to cover the risks that they 

incur operating in this country. We need a strong, sound banking 

system to keep our economy strong. I think it is one of the reasons 

that the U.S. economy has done so well in recent years compared 

to some other countries is that we have a very strong banking system. As a central banker, I would put that priority first. 

But we need to realize that the world has evolved. Institutions 

now are able to globally span, in part is it because their customers, 

if they are dealing with corporate customers, are operating internationally. So to be effective and keep the world economy going, we 

have to deal with that issue. But I would say the first priority 

would be to look at the U.S. 

That is why I think it is important that we continue with the 

time framework and the work plan that we laid out initially, where 

we are working in both directions at the same time, making sure 

the Basel I changes are out the same time as Basel II, that we are 

looking at the impact on the U.S. industry. And then we keep 

working with our fellow regulators from other countries around the 

Basel table and with IOSCO around the securities aspects to make 

sure that internationally we are ending up with a uniform, as 

much as we can get it, a uniform approach to capital and risk. 

Mr. PEARCE. You had mentioned that one of the problems today 

is that different banks are arbitraging their assets. 

Ms. BIES. Yes, the larger organizations——

Mr. PEARCE. That was a statement you made. 

Ms. BIES. Yes, yes. 

Mr. PEARCE. Is that practice one that you would approve of, or 

do you think it is something that we would try to get around in 

the next regulatory cycle? 

Ms. BIES. Generally they are arbitraging it to the extent I think 

it is good because they are saying if we can syndicate a loan, 

securitize an exposure, enter into a derivative transaction, and 

have someone outside the banking system take on risk, then the 

31

bank is stronger and banking system is stronger. The important 

thing is to understand how it is done. 

Mr. PEARCE. No, no. Stop right there. Okay, going back to my 

initial question about the tools, the risk management tools. So my 

question is, if we shift risk outside the banking system, and if our 

formulation for securing the Nation’s economy, therefore the 

world’s economy, is based on factors inside the banking system, it 

seems to me that if you do not have a risk assessment that also 

then brings in those outside institutions, entities, tools, concepts, 

that you are still at as great a risk as you were before you shifted 

the risk outside, and for us not to acknowledge that. 

In other words, I do not know much about risk avoidance. I am 

in politics and I am married, but I know that if you say if they 

move into hedge funds, and hedge funds are not evaluated in your 

formula, and I read all through this formula, and I do not see 

hedge funds. 

Do you see what I am saying? It is that we are fooling ourselves 

to an extent, that if we can just get the risk outside the system, 

that we will be okay. I worry deeply about that concept. 

Ms. BIES. Let me put it in a different perspective. What has 

evolved really in the last two decades is risk management processes where institutions can keep the risk, and these are sophisticated institutions, can keep the risk they understand best and can 

manage, and place the remaining risks with other sophisticated investors. These are sophisticated investors because they do have to 

understand what it is that they are acquiring, whether it is a mutual fund that is looking at the investor direction of that fund, 

whether it is going into a pension fund, and those fiduciary responsibilities. 

The buyers of the risk in one way have better information than 

investors in banks. If you look at data today, we get real-time public data on credit card securitizations that tell you what is happening to current delinquencies and charge-offs. We do not get it 

if that same credit portfolio is sitting in the bank. 

Mr. PEARCE. Mr. Chairman, with your permission, I know my 

time has expired and a vote is elapsing underneath my feet, but 

when I look at the German losses in Asia, when I look at the banking losses in Thailand, when I look at the current exposure in 

China with 30 percent nonperforming loans, I am sorry. I just 

worry about the capital requirements, and then I need to really feel 

we are headed that way. You can respond, and we will put it on 

the record, and I will read it, but I am just getting out of here. 

Thank you. 

Mr. LEACH. Mr. Pearce, I want to thank you for those thoughtful 

comments. We have an uncomfortable marriage at the table apparently. 

Let me say to our panel, we have a vote on, and I would like to 

ask if you could remain for a bit longer. We will recess for about 

15 minutes and then return to this panel before we start the next 

panel. 

The committee is in recess subject to the vote. Thank you. 

[Recess.] 

Mr. LEACH. The committee will come back to order. 

32

For the record, it should be noted that in the process of the vote, 

we had an emergency evacuation of the Capitol, and so we are reconvening at a later moment. The first panel was dismissed because of the emergency. 

One of the current panelists is unable to return, and so without 

objection Ms. Shaw Petrou’s statement will be placed in the record 

in full. Without objection also a letter from the Real Estate Roundtable will be placed in the record. 

Before commencing, I want to make about 1 minute worth of 

comments, having not been able to address the first panel. I would 

just like to say that I think left out of the mix of discussion, with 

one exception, are four very big questions. The first question: 

Should there be greater attention to risk management techniques? 

That is an obvious yes. 

But the second question is, whether there is a great case in today’s economy worldwide for a reduction in capital in the banking 

system. One has to assume that that case is positive to go forth 

with new techniques that are on the table. I do not assume that 

that is a positive answer to the question of whether you have a reduction in capital. 

Thirdly, is there an assumption that worldwide there is sophistication in the banking industry of various countries affected, as 

well as international regulators that are comparable in the United 

State? I think that is a very doubtful answer as well. 

And then the fourth question is, does this better prepare us for 

an international emergency, whether it be economic or political? I 

stress the political because this little event of the evacuation of the 

Capitol is symbolic of the kinds of anarchistic kinds of acts that 

could end up affecting world financial markets. One has to be pretty confident that there is no emergency that is likely to affect international capital markets to put into effect systems that decrease 

the capital in banks. 

Finally, I must say that one of the other questions that has to 

be addressed is whether it wise to reduce capital in foreign countries in the banking system, therefore putting pressure for competitive reasons for us to reduce capital here, therefore putting pressure for competitive reasons if we reduce it for big banks, to reduce 

it for small banks, and whether this is a wise course of action, to 

end up putting an enormous amount of power in other regulators 

in other countries in other banking systems. 

I think these are questions that really at the root have to be 

asked because the testimony of the Federal Reserve of the United 

States today included a surprising amount of assessment that reductions in capital were far larger than expected, and that comparability of standards within the most sophisticated banks were 

far wider than expected, and, therefore, there is a hope that over 

the next 5 or 10 years that they will better understand the circumstance, and that we can move because of the hope that in 5 or 

10 years we are smarter than we are today. 

I think these are assumptions that are really open to very serious review. I would just like to conclude by saying, in my life I 

have always been a very, very strong Fed supporter, but I believe 

that we have gotten an incredibly interesting review of mathematical modeling that may have gotten out of hand and that today 

33

I am a very, very strong Fed supporter, but more of the Federal 

Deposit Insurance Corporation than the Federal Reserve Board on 

this issue. 

With that by opening statement, let me turn to the panel. We 

have with us Mr. William J. Small, who is chairman and CEO of 

First Federal Bank, representing America’s Community Bankers; 

Dr. James R. Follain, senior vice president of Mortgage Valuation 

of Fidelity Hansen Quality; and Dr. Paul S. Calem, vice president 

for Loan Research, Loan Performance. 

Let me begin with Mr. Small. Please proceed. 

STATEMENT OF WILLIAM J. SMALL, CHAIRMAN AND CEO, 

FIRST FEDERAL BANK, REPRESENTING AMERICA’S COMMUNITY BANKERS 

Mr. SMALL. Thank you, Chairman Leach and members of the 

subcommittee. My name is Bill Small. I am chairman, president 

and chief executive officer of First Defiance Financial Corporation, 

a public savings and loan holding company based in Defiance, 

Ohio. First Defiance is a holding company for First Federal Bank, 

and my institution will face direct competition from banks which 

comply with Basel II. 

I appear today on behalf of America’s Community Bankers, 

where I am a member of the board of directors. I thank you for this 

opportunity to present our views. 

An announcement by the bank regulators about the most recent 

quantitative impact study for Basel II reinforces the importance of 

this hearing and congressional oversight of this process. The results of that study highlight the adverse competitive effects that 

Basel II could have in the United States. As ACB testified on this 

issue almost a year ago, we believe that the development and implementation of the Basel II accord would present a significant 

competitive threat to community banks unless it is balanced by a 

carefully revised Basel I. 

Community banks would like to adopt a more risk-sensitive 

model such as that envisioned by Basel II. Unfortunately, the complexity and the cost of implementation of the Basel II model will 

preclude most banks from taking advantage of the positive benefits. 

The bifurcated capital system implemented without proper adjustments to Basel I will open the door to competitive inequities. For 

example, two banks, a larger Basel II bank and a smaller Basel I 

community bank like mine, could review the same mortgage loan 

application. However, under Basel II the larger bank would hold 

significantly less capital than the smaller bank, even though the 

loan would carry the same risk. 

Capital requirements should be a function of risks taken. If two 

banks make similar loans, they should have a very similar required 

capital charge. The most recent quantitative impact study conducted by the banking regulators on Basel II shows evidence of material reductions in required capital for participants. Capital requirements for mortgage loans could drop by more than 70 percent 

for some organizations. There are steep drops for home equity 

loans and other consumer lending products as well. 

These institutions compete head to head with community banks 

in the retail area. Retail lending, especially mortgage lending, is a 

34

fundamental business of community banks. Unless Basel I is revised, smaller institutions will become takeover targets for institutions that can use capital more efficiently under Basel II. ACB is 

pleased that the bank regulatory agencies have agreed to review 

and revise Basel I and implement the changes concurrently with 

the new Basel II accord. Changes to Basel I can include more riskweighted baskets and a breakdown of particular assets into multiple baskets that reflect differences in collateral types, loan-tovalue ratios, and other factors. 

Another alternative would be for the bank regulators to adopt a 

simplified risk modeling approach that is consistent with the less 

complex operations of most community banks. It is important that 

the agencies work cooperatively in this effort and that input be solicited from all affected parties. We would encourage the agencies 

to form an advisory group of bankers to participate in the process 

and to hold public roundtables on these very important issues. ACB 

plans to be actively engaged in this process, and we will assist the 

regulators in any way we can. 

While we expect the regulators to work cooperatively in revising 

Basel I and implementing Basel II, we support the legislation sponsored by Chairman Bachus and Ranking Member Maloney. The 

legislation would require a unified U.S. position on Basel II and 

would require the agencies to evaluate and report to Congress on 

several factors. It is essential that the views of all interested parties are heard and considered and that any changes to capital requirements be done correctly. 

In that regard, ACB believes that a leverage ratio should be retained for all institutions, although it may be appropriate to change 

the requirement from its present level. We also strongly support 

giving the Director of the Office of Thrift Supervision a formal seat 

at the table because of its status as a primary Federal regulator 

of approximately 1,000 banking institutions with over $1 trillion in 

assets. 

We thank you, Mr. Chairman, and the rest of the subcommittee 

members for holding this hearing on the proper implementation of 

Basel II and the sensible revision of Basel I. It is vital to the competitive viability of community banks. 

Again, I thank you, and I would be pleased to answer any questions. 

[The prepared statement of William J. Small can be found on 

page 166 in the appendix.] 

Mr. LEACH. Thank you very much, Mr. Small. 

Mr. Follain? 

STATEMENT OF JAMES R. FOLLAIN, SENIOR VICE PRESIDENT 

OF MORTGAGE VALUATION, FIDELITY HANSEN QUALITY 

Mr. FOLLAIN. My name is Jim Follain. I spent nearly 30 years 

as an economist specializing in housing and mortgage markets. 

My comments this morning are based upon joint work with Dr. 

Paul Calem. Paul has spent 20 years as an economist at the Federal Reserve Bank of Philadelphia and the Federal Reserve Board 

and studied many aspects of the banking industry. Paul and I appreciate the opportunity to share our views with you. We will sumVerDate 0ct 09 2002 14:39 Jan 11, 2006 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 G:\DOCS\109.27 RODNEY
35

marize the major points contained in the written statement we submitted to the committee. 

Before getting to the primary subject of our testimony, we just 

want to express our support of the broad goal of Basel II, to bring 

out better alignment between regulatory capital rules and the 

riskiness of bank portfolios. Indeed, we have actually written another paper that offers support of the specification of the proposed 

minimum capital rule that will apply to an important asset type, 

the newly originated 30-year fixed rate mortgage for prime borrowers. 

Today, we wish to offer our opinions about another aspect of the 

proposal, the potential competitive impact of the proposed implementation plan in the market for residential mortgages. We believe 

that the proposed bifurcated implementation plan in Basel II in the 

U.S. is likely to have a significant impact on the competitive landscape within the banking industry in its competition for residential 

mortgage investments. The primary impetus is the sizable decline 

in minimum regulatory capital requirements for residential mortgages that will be available to adopting banking organizations relative to the requirements that will continue to apply to non-adopting banking organizations. 

The decline for adopters will likely trigger a regulatory arbitrage 

process in which non-adopting banking organizations may experience a non-negligible reduction in net income due to a reduction in 

their share of the market and the reduced price they earn on such 

investments. Based upon available data and plausible assumptions, 

we calculate the aggregate gain to adopters to be about $300 million per year once the Basel II plan is implemented. Losses to the 

non-adopters we calculate to be about $900 million per year. They 

stem from two forces: their share in the market decline and the income earned per dollar of debt owned declines. 

These losses would not be uniformly distributed among all nonadopters. The mortgage specialist among non-adopters would be 

most impacted by the proposed rule, in part, because the marginal 

amount of regulatory capital will likely be the leverage ratio, and 

not the Basel I capital rule. A subset of these with relatively large 

amounts of ARMs, adjustable rate mortgages, would be among 

those likely to be most at risk from heightened competition from 

the adopters. 

Potential and partial remedies to the problems we envision are 

possible. In particular, the capital rule pertaining to residential 

mortgages for non-adopters can be adjusted downward for the credit risk embedded in them. Something like the risk weights associated with the standardized approach would likely reduce substantially the potential for competitive inequities. These reduced risk 

weights would be assigned to banking and saving organizations 

with geographically dispersed investment portfolios and interest 

rate risk management systems and processes designed to keep such 

risks to levels acceptable to regulators. 

We would be glad to answer any questions you might have. 

[The prepared statement of James R. Follain can be found on 

page 63 in the appendix.] 

Mr. LEACH. Thank you very much. 

Dr. Calem, were you going to testify or just answer questions? 

36

Mr. CALEM. Answer questions. 

Mr. LEACH. Fair enough. 

Let me first turn to Mr. Small, but for any of the three of you. 

It strikes me that we are in a bit of a different world than we have 

ever been in before, with the new reliance on derivative kinds of 

products. Derivatives are wonderful ways to reduce risk for individual institutions in individual circumstances, but there is an argument that sometimes the totality and size of the market may increase some risk to the system as a whole in the case of something 

that goes astray. 

In this circumstance, there are two very large questions that I 

have never really heard addressed on Basel II. One is, in a world 

in which the notional value of derivatives is in the multi-trillion 

dollar range, the last I heard, six or seven times the GNP of the 

United States, is there a case for reducing capital in the system 

that should be considered compelling? Because if you have an 

emergency, you need to have a lot of stability. 

The second question I would like to ask, and this is a really bizarre one because it runs contrary to all regulation in my lifetime 

that I know of. That is, there is an assumption that bigger institutions need substantially less capital than smaller institutions. The 

assumption goes along the lines that smaller institutions are smaller markets, too much concentration, and a bigger institution has 

wider portfolios, et cetera, and wider diversity. 

But this really can be carried to an extreme. I contrast capital 

ratios, for example, in my rural State of Iowa, which is considered 

disproportionately agricultural. It is not as much as people think, 

but it is disproportionately so, versus New York. Capital ratios in 

a community bank in Iowa in terms of tier one capital are very 

often four-fold a larger bank, sometimes six-fold a larger bank. And 

capital is the way one controls market presence, in other words, the 

competitive nature of the landscape. And so one of the really big 

questions is, in this world that is so complicated with the big playing such a large role, might there not be a case that the big should 

be required to have increasing amounts rather than decreasing 

amounts of capital? 

I would like you to address both of these questions. Does the fact 

of the threat to the stability of the system of derivatives mean that 

we should be more concerned, rather than less concerned, with capital? And does the fact that the big have surprisingly small levels 

of tier one capital imply that our real concern should be raising 

their capital base, rather than lowering it? 

Let me ask this first to Mr. Small. 

Mr. SMALL. First of all, we certainly support the fact that there 

still needs to be a leverage ratio out there. But I do believe that 

especially since the implementation of Basel I back in 1988, at 

least in a general sense we have all hopefully become much more 

sophisticated in our risk measurement and risk management tools 

that we use in our institutions. 

That being said, we still support the fact that we do need to have 

a minimum leverage ratio. We think it needs to be looked at. There 

needs to be some flexibility, I think, in where that level is set. At 

this point in time, I am certainly not prepared to speak for where 

37

we think that level should be, but we certainly think it needs to 

be reviewed. 

From the standpoint of the larger institutions and whether they 

should possibly be carrying more capital because of their diversity 

products and services and instruments that they are utilizing on a 

daily basis, again hopefully because of their size and their risk 

management procedures that they have in place right now, that 

they have taken the precautions necessary. 

As you mentioned in your opening remarks, nobody can control 

what happens in the event of a catastrophe such as we experienced 

a few years ago; that certainly could have a major impact. But for 

day-to-day operations, I am not going to sit here even as a smaller 

institution and argue that I think the larger ones should have a 

higher capital level. 

Mr. LEACH. Let me be very precise. 

Mr. SMALL. Okay. 

Mr. LEACH. I do not think I described it precisely. I did not mean 

more capital to the smaller institution, but more capital than is 

currently the case, with the relative differentiation between small 

and large narrowing, rather than widening. 

Mr. SMALL. In other words, are you saying should there be a 

higher capital level than what we require today? 

Mr. LEACH. Yes. 

Mr. SMALL. In my estimation, no. I do not feel that that is necessary. 

Mr. LEACH. Let me ask the same question of the other two. 

Mr. FOLLAIN. Sir, I am a mortgage specialist, Mr. Chairman. In 

the case of mortgages, I can tell you a couple of things. If a bank 

has a very geographically diversified portfolio, it probably needs 

about half the capital for credit risk than a regionally concentrated 

portfolio has. But the problem with mortgages is that most of the 

risk is on interest rate risk. So whether those diversification benefits, I do not think apply on the interest rate side as much as they 

do on the credit side. 

Mr. LEACH. Yes, fair enough. That is interesting. 

Doctor? 

Mr. CALEM. Yes, Mr. Chairman, Mr. Leach, I would add that I 

think the market risk and interest rate risk aspects of bank risk 

are separately addressed in the regulatory framework. There is a 

separate framework for market risk that addresses derivatives in 

the trading portfolio. Interest rate risk is also addressed under Pillar 2 of Basel. I think overall that it seems to be appropriate. The 

Basel II accord is really meant to focus on credit risk. 

I do agree that it is a legitimate concern that with all the focus 

on credit risk because of Basel II, some attention may be drawn 

away from these other risks. The framework is there to ensure adequate capital, but there may be a legitimate concern that the attention is being drawn away from these other risks which could be 

more substantial than credit risk. 

Mr. LEACH. Let me just conclude partly with an observation to 

Mr. Small. The FDIC is suggesting there ought to be a lot more attention to maintaining a credible leverage ratio. The Fed today 

technically said in theory that was right. It strikes me, one of the 

things Basel II is doing is it is saying in an international setting 

38

that may not be the case, where the FDIC might demand it to be 

the case here at home. 

So it strikes me that if I were negotiating on behalf of the United 

States, which the Fed is doing, that we ought to in a panicked kind 

of way tell the Basel II committee we need to put more emphasis 

back on the leverage ratio as an absolute minimum requirement 

and that we ought to be listening to the FDIC very strongly in this 

regard because if we do not, all the international banks are going 

to be cutting back their capital substantially, then our large banks 

are going to say that is a case for competitive reasons they have 

to cut back our capital. Then our smaller banks are going to say 

that to compete with the big banks, they will have to cut back their 

capital too. 

So it ends up that the banks outside of America are going to be 

having a profound influence on the safety and soundness of banks 

within America. Then because of the derivatives world in which everything is international, the whole stability of the derivative system is going to be based on the weakest, not the strongest, and we 

are going to have a larger number of weaker institutions. This is 

a bizarre circumstance, given virtually every scenario that I have 

seen in economics about the notion that the world financial system 

is based on reeds of strength, assuming everything is stable. 

The minute you introduce startling instability, we have some 

problems. If you have problems, it is nice to have a little extra 

cushion. I see this as a movement away from cushions. Now do you 

see it that way, or do you see it very differently? 

Mr. SMALL. I do not see it differently. I do agree, and I hope that 

the U.S. continues to take that stance. We do need a safety net. 

We have to have some minimum leverage ratios out there. I totally 

agree with that. 

But I also think that it is time for us to reassess what the proper 

level for that is. Once we get that determination, I think it is important for us to try to drive that as far as the international market is concerned. 

Mr. LEACH. Thank you. Let me just finally conclude with one aspect of the Fed testimony today that is truly profound to me. The 

Fed in its statement acknowledged that its requirements will be 

substantially stronger than are necessary. It said, however, we are 

going to have protection because the market will force people to 

have higher standards. That is their testimony. The market will 

force people to have higher standards. 

I am a little bit in disbelief. I think there is a distinction between 

the public interest and the private interest. The public interest is 

for credible capital. A private institution in many cases wants to 

go at the minimum it can and leverage as much money as it can 

because it gets a higher rate of return for its shareholders. I think 

we have to have public regulation that protects the public first and 

not rely on others to assume that we are going to get higher capital 

ratios and they are required by public regulators. 

I personally have never in my life read more unsure testimony 

from a regulator than I read from the Federal Reserve of the 

United States today. I think that that testimony ought to be read 

with great care by outside observers. The Fed has gotten involved 

in a process that it acknowledged in its own testimony is out of 

39

hand. It did not say ‘‘out of hand.’’ It simply said two things. It said 

the reductions in capital are far greater than it predicted, and it 

said there is no comparable standard within the banking industry 

for looking at this. That is in the United States banking industry, 

in the most sophisticated institutions. 

It drew no conclusions about worldwide. If that is the case in the 

United States, what in heaven’s name is it when you include 40 

other countries with 40 other regulatory systems? I think we have 

been presented a truly interesting mathematical approach to new 

regulation, but as interesting as it is, it is something that we 

should be profoundly concerned about. 

Anyway, I want to thank the distinguished subcommittee chairman, who has really led this committee in a very interesting way. 

My hat is off to him. Spencer, I want you to return to your chair 

and take over. Thank you all. 

Mr. BACHUS. [Presiding.] Thank you, gentlemen, for persevering 

under the difficult circumstances. When I returned to the hearing, 

there was a line out the building. I figured it was people trying to 

get into our hearing. It must have been wonderful testimony. 

[Laughter.] 

I started back over here, and in the rush of people coming out 

of the building, I thought we had recessed the hearing. It turned 

out it was something else. 

Dr. Follain and Dr. Calem, let me address this first question to 

you all. Your study on the effect of Basel II on the mortgage industry, the competitiveness within it, seems to come to a different conclusion than a later study by the Federal Reserve. Why do you 

think your results differ from their recent Fed study? I think I 

know part of the reason. They made some assumptions that simply 

are not true. 

Mr. CALEM. Okay, I will take that question, Mr. Chairman. 

The way I view the differences in our studies is essentially, like 

you say, a difference in some basic assumptions or the basic paradigm. A simple way to think about it, there are essentially three 

sectors in the mortgage market that are relevant to this question. 

There are the larger banks, smaller banks, and non-banks. Let’s 

focus on the nonconforming market and leave aside the question of 

the GSEs and the conforming market. 

I think the Fed view is that the regulatory capital arbitrage that 

is occurring now is essentially all that can occur. Right now under 

Basel I, it is clear that capital requirements for low-risk mortgages 

are too high and, therefore, there is a certain amount of arbitrage 

of selling the low-risk mortgages off to non-bank investors in the 

secondary markets. We are talking now about banks’ nonconforming mortgages. 

The Fed view is that what is occurring now essentially is all that 

can occur. When we change the environment between big banks 

and small banks, it will not have any effect except that the big 

banks essentially will no longer have to arbitrage. They will not 

have to sell what they are selling now. There will be a more level 

playing field between them and the non-banks. The smaller banks, 

for whatever reason, they are either already selling whatever they 

can sell or want to sell, or there is going to be no change in their 

incentive to arbitrage. 

40

The way we view it is that with these three different parties, we 

agree with the first part that you level the playing field between 

the big banks and the non-banks. There will be less reason for big 

banks to engage in this regulatory arbitrage for mortgages and sell 

to the non-banks. They can now hold them and not have to hold 

as much capital. 

We feel that there is going to be a new opportunity, in a sense, 

for the small banks or new pressure for the small banks to lay off 

that risk. I think what I heard Governor Bies say is that smaller 

banks do not have those opportunities to sell to non-banks. They 

do not have as much opportunity to arbitrage this capital for mortgages right now. The question is, well, if you remove at least the 

barrier allowing the mortgages to shift between them and the large 

banks, won’t that have an effect. 

We believe it will. We believe that there are clearly transaction 

costs in doing this regulatory capital arbitrage, selling loans, 

securitizing loans. We feel that the transactions costs for that activity for smaller banks will be significantly lower for those smaller 

banks vis-a-vis big banks than they are vis-a-vis the general market. Those loans will be able to transfer much more readily than 

they can now. 

It is a big change in the environment. At the very least, we do 

not know that the relationship between small and big banks is the 

same as the relationship between small banks and the non-bank 

sector. We feel that the transfers that are not occurring now will 

be able to occur because the relationships are different. There are 

correspondent relationships. There is direct competition in market 

share. So I think it is a very fundamentally different paradigm 

from the start, basic assumptions in terms of the regulatory arbitrage opportunities before and after. 

That said, we are perfectly willing to acknowledge that we cannot make precise estimates of what the shift will be. Based on 

available evidence, based on some assumptions concerning the responsiveness of market share to these differences in cost, we have 

come up with a number. But we will readily acknowledge it is an 

illustrative number. Small banks obviously will have a competitive 

response. Maybe they will shift into other areas. But the basic theory is where we differ, and I think our view is that these numbers 

do illustrate the potential for a substantial competitive effect. 

In fact, our numbers only look at first mortgages. When I was 

at the Fed, no one asked me the question why you include home 

equity loans in your calculation. That would have raised the competitive effect. No one questioned it. That was a clear omission. I 

would have questioned it myself, but no one asked me that. 

Thank you. 

Mr. BACHUS. Okay. 

Dr. Follain, would you like to comment further? 

Mr. FOLLAIN. I generally agree. A lot of my experience is based 

on my time with Freddie Mac when I was director of capital management for the credit risk side. I found it to be an extremely competitive business. A few basis points here and there mattered. 

Mr. BACHUS. I am sure. 

Mr. FOLLAIN. That kind of influenced my thinking. I was part of 

the alliance wars between Freddie and Fannie and big shifts in 

41

shares during that time. So something like Basel II that has the 

ability to change capital so much, my intuition is you are going to 

see a lot of the kind of things Paul just talked about. 

Mr. BACHUS. Capital requirements have always affected competitiveness, the amount of the reserve you have to hold. I mean, it 

would almost work against market forces for it not to have a significant effect. 

Mr. CALEM. You can make a valid theoretical argument, which 

the Fed is making, that if there are three parties, the big banks, 

small banks, and non-banks, the non-banks already have that competitive affect. They are already drawing away the loans from then 

smaller banks, to the extent that is possible. Okay? 

Our view is that with these three parties, that when you free another channel for that income to shift to, the big banks, that will 

have an effect. Not all of that income is shifting now to the nonbanks. Some of it will shift once you open that other channel, 

which we feel is a channel with lower transaction costs, that income will shift to it. In theory, their argument has validity and, 

granted, it is very difficult to prove either theory. 

Mr. BACHUS. Why should I as a policymaker, why should this 

Congress, why should it be concerned about potential competitive 

impacts of Basel II as a practical matter? 

Mr. FOLLAIN. I think it is a great question. There are a couple 

of reasons. The part I want to emphasize is the importance of interest rate risk. I am a mortgage guy. I am not going to talk about 

other kinds of things. Interest rate risk is two or three times as 

great as the credit risk in mortgages. Whenever you change the 

competitive balance, the non-adopters, the ones being disadvantaged, I think it is going to have an incentive to take more risk. 

How do you do that in mortgages? You take more interest rate risk. 

That is one way. There is sub-prime and things of that sort. 

What we would encourage you to think about—and there was 

partly a question this morning about adequate resources—I would 

just make sure that the system has enough resources to really 

measure and manage interest rate risk on mortgages because that 

is where the money is, as I used to say. I think as a policymaker, 

that is a really important issue. 

Mr. BACHUS. All right. 

Mr. SMALL. I also think the competitive differential that would 

result from this would certainly lead to some consolidation in this 

industry that really is not in the best interest of the general public. 

When you have the larger banks that increase the value of their 

currency because of the level of capital that they have to carry and 

also looking at the attractiveness of the higher capital levels of the 

smaller institutions, I think it is definitely going to have an impact 

on the consolidation of our industry, much more so than the normal 

cycle of business would have. Again, personally, I do not think that 

is good for the consumer. 

Mr. BACHUS. Well, the existing consolidation within the U.S. 

banking industry is already a concern to the committee. I think it 

clearly would be accelerated by the regulatory capital requirements 

of Basel II. 

Governor Bies today mentioned that if we change Basel I, I guess 

lower the capital requirements there for all the other banks to 

42

more align them, that that would ameliorate some of the differentials in competitiveness. I suppose that would obviously be true. 

But is there a problem there? 

Mr. FOLLAIN. I think for the bank that has a geographically diversified portfolio, a lot of things. There are ways of reducing the 

weights that would help. The problem, and it came up this morning 

on the risk adjusted leverage requirement, for the mortgage specialist who specializes in the adjustable rate mortgages, high quality prime mortgages, that would not be enough. You would have to 

do something with the leverage requirement, I think. 

Mr. BACHUS. In fact, I think John Hawke has talked about that. 

I saw some mention of the fact that if you lowered those requirements, what if you lower them below what ought to be safe from 

a safety and soundness standpoint. You would not want to lower 

the requirements of Basel I if the requirements of Basel II are too 

low from a risk standpoint. 

Mr. CALEM. I would reiterate that Basel II is only a credit risk 

standard. So especially when you are lowering risk weights, you 

have to put additional attention on interest rate risk, market risk, 

concentration risk, et cetera. If you have done that, I think once 

you have that monitoring in place, it is appropriate to lower the 

credit risk standard. 

Mr. BACHUS. I will tell you that I am dealing with a new spokesman at the Federal Reserve. I can tell you that from the middle 

of last year to January when I read in the American Banker about 

your study, I had repeatedly asked them, is no one at the Fed concerned about competitive advantages? I was told by the Vice Chairman of the Fed that that was not a concern that had been expressed by anyone at the Fed. So I was surprised to see that you 

all apparently did not exist. 

[Laughter.] 

Unless the two of you all were doing that work in a closet and 

no one else knew about it or looked at it. 

[Laughter.] 

I do not know what you would term that or have some words you 

want to share at this time. 

Mr. Small, let me ask you this. I know you are concerned about 

community bank competitiveness if Basel II only applies to the bigger banks. I guess that assumes no changes in Basel I. It may be 

hard to bring Basel II to all institutions because of what you talked 

about, the cost and the complexity. 

There again, John Hawke, I will read you what he said, which 

I think ought to be disturbing to all of us. ‘‘The Basel II process 

has generated a product of vast complexity. Thousands of pages of 

task force and working group papers years in the making have 

given rise to hundreds of rules, guidelines, and standards saturated 

with arcane mathematical formulae.’’ That is when I asked to see 

the formula, and I was shocked when they brought it to me. 

I understand from the testimony today and what my staff tells 

me, you can change their variables within that formula, too, which 

makes it even more complex than what was displayed earlier. 

Here is what he goes on to say, ‘‘They are not written by or for 

bankers or, for that matter, by or for conventional bank examiners. 

They are written for mathematicians and economists.’’ He goes on 

43

to say that ‘‘this complexity will have a cost in terms of credibility 

and public acceptance for legislators, customers, and market participants who cannot penetrate the new rules. Can we expect them 

nonetheless to love and respect them? I think it would be well to 

consider whether we are not approaching that point of perfect impenetrability that makes honest compliance difficult, if not impossible.’’

I guess if it is impenetrable to the point of not being able to figure it out, how do you comply with something you do not understand? If bank examiners cannot understand it and bankers cannot 

understand it, how do you comply with it? 

Mr. FOLLAIN. May I just give you an example of the issue? We 

understand the formulas and there are people like that, but what 

I heard this morning was essentially what I think I heard was this 

one particular variable. It is the loss given a default. The range of 

estimates on that is very wide. That is a very important issue. In 

the future, you will want to focus on that one. 

If you look over the last 4 or 5 years, when mortgages have been 

defaulting, the housing market has been great and they have not 

lost very much money. The OFHEO rules for Freddie and Fannie 

talk about a severity of 60 or 70 percent. So how they come up with 

that number is really critical. 

Mr. BACHUS. Thank you, gentlemen. 

Mr. CALEM. I would agree with Jim. I do not think the problem 

is so much the complexity of the rule as its application and the 

ability to calculate those parameters, the probabilities of loss 

severities from existing data, and the ability of the supervisors to 

validate those calculations. 

Mr. BACHUS. Right. 

Mr. Small, I guess part of my question was because of the cost 

and complexity, does it make sense to maybe have a simpler Basil 

I(A) or something? I think Chairman Pryce referred to that, just 

the fact that maybe we need to simplify Basel I or clarify it before 

we go on to Basel II. 

Mr. SMALL. We certainly would not object to moving ahead with 

that. I do think that there is a strong case to be made for developing a Basel I(A), whether it is looking at more of the risk baskets 

or just from the standpoint of evaluating what is the collateral 

type, what is the loan to value, credit scores and so on, or whether 

it is a case of allowing the regulators to develop a more simplified 

methodology for developing that Basel I(A) level that does not have 

the complexity that Basel II has. 

We certainly feel that there is a strong case to be made for that 

and also feel that there is no reason why that should not be pursued as we continue to work toward Basel II. 

Mr. BACHUS. Okay. 

I am told that I have to conclude the hearing. There is another 

hearing scheduled at 2 o’clock, and they have to clean up all this 

mess here that we have created. So with that, we are adjourned. 

I want to thank you gentlemen for your testimony. 

Mr. FOLLAIN. Thank you for asking. 

Mr. BACHUS. Thank you for your contributions to this issue. 

Thank you. 

[Whereupon, at 1:50 p.m., the subcommittee was adjourned.] 

(45)

A P P E N D I X

May 11, 2005

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